All-weather diversification

Key points:

• Increased globalisation and easier central bank monetary policy have made it more difficult to diversify portfolios in this century
• Bonds and commodities are among those assets becoming far more correlated since the pandemic
• Macroeconomic factors, like growth and inflation, can also influence correlations between assets
• It should come as no surprise that inflation is most negatively correlated with fixed income assets, while being positively correlated with commodities. Growth is most positively related with equities
• Cross-asset correlations can change quickly and it might be worth considering linking portfolio diversification decisions with the prevalence and co-movement of macro indicators.  

Diversifying across different asset classes, rather than putting all your eggs into one basket, has usually been the best advice when diversifying portfolios. A global financial crisis (GFC), the impact of globalisation and splurge in central bank liquidity have turned traditional investing norms on their head, and made it more difficult to diversify. What can investors do?  

Increased globalisation in the last decade has helped to make it more difficult to diversify. Investing in a wider pool of assets, rather than just equities and bonds, can help to diversify portfolios.

Global financial crisis leaves a stain

The correlation between asset classes has increased considerably since the early 2000s. Looking at investing in a broad range of key assets before the global financial crisis (GFC), between then and the pandemic onset early last year and then since, shows different levels of correlations.

Whether before or after the GFC, or then to the pandemic, government bonds and commodities were relatively little correlated with other asset classes. This implies that they seem good diversifiers for riskier assets, such as high yield debt or equities. That said, the correlations of commodities have been more pronounced since.

Macroeconomic factors matter

One potential solution to increasing portfolio diversification opportunities, in addition to say investing in private markets, is to better understand the drivers of the co-movement between asset class correlations. In this sense, macroeconomics plays a key role.

Traditionally, growth and inflation are used as macroeconomic indicators, driving returns in financial markets. Indeed, growth (or the lack of it) can account for much of the difference in how asset classes move against each other, while inflation frequently helps real assets, such as commodities, to outperform. In addition to growth and inflation, monetary policy is another driver. This has become more evident since the GFC as monetary policy has changed from traditional, pre-GFC, norms.

It should come as no surprise that inflation is most negatively correlated with fixed income assets, while being positively correlated with commodities. Growth is most positively related with equities, cyclical commodities and real estate, while weighing on returns of gold. The easier monetary policy conditions seen since 2008, and even more so since the pandemic, created an environment where riskier fixed income and equities thrive, while returns on developed government bonds falter.

Time for a tactical tilt?

Given that asset classes have become more correlated over the last decade and that groups of asset classes (perhaps risky, cyclical or real assets) are associated with specific macro “weather”, this information can help to find short-term, tactical overlay portfolio strategies. One might be overweighting assets that benefit from the current economic environment.

But it’s not that simple

In recent years, macroeconomic factors themselves have become more correlated. Inflation, in particular, has been more correlated to growth and monetary policy in the last decade. In a world when everything is correlated, it might be tempting to focus on high-returning assets.

Perhaps. However, correlation trends in macro indicators can reverse. And quickly. As such, it may be worth considering linking portfolio diversification decisions with the prevalence and co-movement of macro indicators.

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