Solving the diversification conundrum

Key points:

• Increased globalisation and easier central bank monetary policy have made it more difficult to diversify portfolios
• The change in correlations since the global financial crisis triggered by central bank asset-purchases and government spending programmes to tackle the pandemic makes it even more difficult to diversify portfolios
• Macroeconomic factors, like growth, inflation and monetary policy, can also influence correlations between assets
• Among the above macroeconomic variables, inflation is most negatively correlated with fixed income assets, while being positively correlated with commodities. Growth is most positively related with equities
• In looking at ways to diversify portfolios more effectively, linking portfolio diversification decisions with the prevalence and co-movement of macro indicators may be worth considering.  

Traditional ways of investing have been turned on their head following the global financial crisis (GFC), increased globalisation and hike in central bank liquidity, making it tougher to diversify portfolios. Is there a solution for investors?

Global financial crisis

Asset classes are far more correlated with each other than was the case a decade ago or so. Looking at investing in a broad range of common assets before the GFC, between then and the COVID-19 pandemic hitting early last year and then since, shows their correlations have altered.

Whether before or after the global financial crisis, or then to the pandemic, government bonds and commodities were relatively little correlated with other assets. This implies that they seem good diversifiers for riskier assets, such as high yield debt or equities.

That said, the change in correlations since the GFC, brought about by central bank asset-purchases and intended to stabilise asset prices, and unprecedented government spending programmes has made it more difficult to diversify portfolios. Investment grade bonds have become more correlated with other asset classes and commodities have lost some of their appeal as diversifiers through higher correlation.

The influence of macroeconomic variables

One potential way to improve portfolio diversification decisions, in addition to perhaps allocating to private markets, is by having a better understanding of the drivers of co-movements between asset class correlations. This is where macroeconomic variables can help.

Traditionally, growth and inflation are common macroeconomic indicators, driving returns in financial markets. Indeed, growth (or its lack) can account for much of the difference in the co-movement of assets, while inflation frequently helps real assets, such as commodities, to outperform. In addition to growth and inflation, monetary policy can be another driver.

It should come as no surprise that inflation is most negatively correlated with fixed income assets, while being positively correlated with commodities. When it comes to growth, it is most positively related with equities, cyclical commodities and real estate, though weighs 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 prosper, while returns on developed government bonds struggle.

Tactical tilts

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

But it’s more difficult than that

Also, macroeconomic variables have become more correlated with each other in recent years. 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.

But there is a danger to acting as if history is a guide to future correlations. Correlations between macroeconomic variables can reverse. And quickly. As such, perhaps it’s time to consider linking portfolio diversification decisions with the prevalence and co-movement of macro indicators.

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