By Andy Warwick
This year has finally seen the return of performance dispersion across asset classes following the higher correlations we have seen since the financial crisis. This is good news for investors.
Lower correlations mean more opportunities to generate returns irrespective of how the market is behaving. In low correlation environments, diversification brings real benefits – as long as you diversify in the right way. Investor skill comes to the fore.
In many ways, the changes in the markets we have seen this year represent something of a return to normality. Historically, rising equity prices have been associated with falling bond prices (rising bond yields) as stronger economic fundamentals have driven investors to stocks and away from bonds, and weaker economic growth had the opposite effect. However, over the past few years, particularly in Europe, equity and bond prices began moving together as both markets were inflated by floods of liquidity from accommodative central bank monetary policies, which distorted the traditional relationship. After the US Federal Reserve first hinted it might begin tapering in June last year, markets began returning to lower correlations again.
Quantitative easing is still very much in place in many parts of the world and the bond markets are still heavily influenced by central bank policies, so it would be untrue to suggest that everything is back to normal. But many other asset classes are beginning to unravel, which is presenting both a challenge and an opportunity for investors. In a straightforward risk on/risk off environment, the key objective is to determine your broad asset allocation – there is little to no benefit in choosing the right sector or stock. But in an environment like the present, when each asset class is behaving in its own idiosyncratic way, the market tends to reward (or punish) those more granular decisions.
There are no short cuts to success during periods like this. It takes skill, experience and a willingness to conduct deep research. It is not enough just to make the right call on emerging vs developed markets – you also need to identify the right regions and even countries because the performance differential between regions and countries can be enormous.
Right now, for example, the best emerging market bets are probably those countries that are on the verge of political change. India has just voted Narendra Modi and his Bharatiya Janata Party into power. Modi campaigned on a strongly pro-business, anti-bureaucracy ticket and brings with him a great reputation as a highly effective leader following his time as Chief Minister of Gujurat. If you also consider that India has suffered from chronic underinvestment over the years and has significant unused capacity, it begins to look like a very good long-term bet. Indonesia, which is holding elections on 9 July, also appears very promising in this respect.
By contrast, China has spent the best part of the past decade over-investing and seems to have nowhere to go for the time being at least. Two of the other BRICS darlings – Brazil and Russia – also face challenging periods ahead.
European equities are probably the most attractive of all. Other than the BoJ, the ECB is the most accommodative central bank in the world at present as it works hard to ward off the risk of deflation. Its imposition of a negative interest rate on 5 June was a bold move intended to encourage banks to lend to businesses rather than hold onto money. It looks like the ECB is determined to do whatever it takes to stimulate the eurozone economy, which will only be good for European equities, which are around 18 months behind US equities and attractively-valued given the global growth backdrop.
Andy Warwick is a portfolio manager within BlackRock’s diversified strategies team
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