Why the return of diversification between asset classes is good news for investors
Investors have been deprived of the benefits of diversification since the financial crisis as equity and bond returns have mostly been moving in tandem. But the correlation between asset classes has started to fall away, just as it has within equity markets themselves.
Diversification is one of the main pillars of successful investing, because it leads to opportunity and opportunity leads to returns. It also offers lots of room for active management. Data now supports what active portfolio managers are experiencing: diversification is back. Since the third quarter of last year, there has been a change in the investment landscape. With the reflation of economic growth and normalisation of interest rates, diversification between equity and bond risk has returned, as shown by rolling correlation between eurozone government bonds and MSCI World indexes.(Figure 1) The picture is very similar for US Treasuries.
In the years after the financial crisis, investors were often deprived of diversification, as equity and bond returns mostly moved in tandem. Policymakers were preoccupied with managing the economic fallout, acting mainly through monetary policy and moving interest rates aggressively lower. This propelled the performance of bonds, but also propped up equity prices. The latter only faltered periodically, when the market lost confidence in the ability of policymakers to revive the economy. Economists and investors alike have wondered what the road out of the abnormally large monetary stimulus and historically low interest rates would be like. Luckily, the type of normalisation we have is agreeable, as it is growth-led. Economic growth is improving and unlike the first green shoots seen before, it is now more synchronised across the globe. Europe and large emerging economies are catching up at a time when the US economy and profit cycles are maturing. With the US Federal Reserve in the lead, central banks are slowly reverting to their former role of leaning back and managing the business cycle. Since this normalisation is growth-led, equity prices have been able to move higher, despite the increase in interest rates.
More diversification among equity sectors
Data suggests that the diversification opportunity is not only improving between equities and bonds, but also within equity markets. (Figure 2) The return correlation between the 11 MSCI World industry sectors, for example, has fallen substantially. This is part of the same story. When economic growth picks up from a low base, the dispersion in performance between industry sectors increases. With correlation falling, the return potential from an active sector allocation in the equity portfolio increases.
In stark contrast to equities, the diversification opportunity within bond portfolios is diminishing. The correlation between the different segments, including government bonds, investment-grade corporate bonds, high yield, covered bonds and emerging market bonds – has risen dramatically. Despite being growth-led, normalisation of interest rates is harsh for bond portfolios, as coupon income has been eroded over decades of interest rate decreases. When rates go up, there are therefore few places to hide from capital losses.
A return to growth and risk-taking
Looking at the future, the progression of the world economy will rely less on the US and more on the rest of the world. Stable financial conditions are prolonging a virtuous cycle of economic progress. This environment lends itself to moderate risk-taking and seeking the benefits of diversification. We favour equities in a balanced portfolio, with distinct sector stances in order to benefit from the cyclical dispersion in corporate profits. Future bond returns will be constrained by higher interest rates and diminishing diversification. Scaling back and allocating to higher carry bonds is one way for bond investors to navigate the path back to more normal rates.