Investment Newsletter May 2018
Cause and effect They say that the economy and the stockmarket are a bit like a drunk and his dog. The drunk weaves around all over the place. The dog is a little steadier and walks his own path. However, they can’t get too far apart because the dog is on a leash. The stockmarket often acts like it is drunk. It can be wildly unpredictable and the correlation to what is happening in the real economy can seem tenuous at best.
Mike Deverell Investment Manager
Equilibrium Investment Management
Take the recent UK economic growth figures for the first quarter of this year, which were unexpectedly weak. You might expect the UK stockmarket to dip on the news but nothing of the sort happened. In fact, the market has generally gone up since the news. For many stocks in the top 100 the correlation can often work like this… Poor economic news = no rate rise for now = a fall in the pound = a rise in the value of earnings made overseas = a rise in share price
In finance we often talk about correlations and knowing the correlation between different asset classes is vital for portfolio construction. One problem with this is that correlations are not constant. Traditionally, government bonds such as UK gilts have been lowly correlated to equities, however this has not been constant. Chart 1 shows the rolling 12 month “beta” of the FTSE Conventional Gilts Index relative to the FTSE All-Share Index of UK equities. Beta is a measure of correlation – a beta of 1 means perfect correlation and so if the stockmarket goes up 10% then we’d expect gilts to go up 10%. A beta of -1 means if the market goes up 10% we’d expect gilts to go down 10%. For most of the time, the beta is between 0.2 and -0.2 – low or sometimes slightly negative correlation. This
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter May 2018
has historically made a portfolio of equity and bonds a good investment with your bonds tending to hold value (or even go up) at times when equities go down. Given that for the past few decades government bonds have mainly been going up in price (as their yields or interest rates come down) this means a portfolio of just bonds and equities has done very well. Chart 2 shows the risk and return of a portfolio of 60% FTSE All-Share and 40% gilts (blue dot) compared to its component parts, over the past 10 years. The higher the dot is on the chart, the higher the return. The horizontal axis shows the volatility – more volatile is further to the right. The 60/40 portfolio (rebalanced once a year) has actually slightly outperformed the 100% equity investment but with less volatility.
We prefer to include other asset classes in portfolios such as commercial property and alternative equity. These bring further diversification and the potential for additional sources of return. This extra diversification has worked over this period, but it is particularly important when the correlation between equities and bonds increases. Chart 1 shows that the correlation spiked dramatically last year to almost 0.9 and has remained at elevated levels ever since. Anyone who had bought a 60/40 portfolio based on the previous decade’s correlation would have been caught out since the beginning of 2018 as equities and bonds sold off at the same time. Thankfully, we also held other assets in the portfolio which went up at the time that both these assets dropped.
Chart 1:
Source: FE / Equilibrium Investment Management LLP
Chart 2:
Source: FE / Equilibrium Investment Management LLP
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter May 2018
Correlation vs causation
If we need to be wary about how we use correlation we also need to think hard about causation. As a keen runner, I’ve noticed that when I wear sun cream on a run I tend to struggle. There’s a definite and noticeable correlation. Therefore I shouldn’t wear it. This is of course, nonsense. There’s a third causal factor in play; the sun. I only wear sun cream when it’s hot and sunny. A hot day also means I tire more quickly. In the same way, the fact that bonds and equities sold off at the same time doesn’t mean that the bond sell off caused the equity sell off or the other way around. Both asset classes have been hit by outside factors, in particular the Federal Reserve reversing their quantitative easing programme (QE). We believe both equity and bond prices have been driven up by QE and ultra-low interest rates. Therefore, increasing rates and reverse QE could have the opposite effect on prices.
Spurious correlations
The other thing we need to watch out for is spurious correlations. Sometimes two unconnected things can appear to go in the same direction for no apparent reason at all. The website www.tylervigen.com/spurious-correlations has a great collection of charts showing spurious correlations. Who knew that the divorce rate in Maine would have a 99% correlation with margarine consumption (chart 3)?
There is a counter argument to this, which is that historically equities have tended to do well in a rising rate environment. Usually rates are going up when the economy is very strong, which is of course good for equities. Again, this is a correlation we need to be wary about in our view. This year is likely to see less growth than last year, although it will still see growth. We don’t often see rate increases in a slowing economic environment, and we have never really seen reverse QE before. In our view it therefore remains important to have multiple sources of returns in portfolios. We have less equity than usual but still a decent level of exposure, both directly and indirectly. However, we will continue to hold less in bonds for now as we expect they will diversify our portfolio less well than they have done historically.
Disclaimer: The content contained in this newsletter represents the opinions of Equilibrium investment management team. The commentary in this newsletter in no way constitutes a solicitation of investment advice. The value of your investments can fall as well as rise and any past performance quoted is not a guarantee of future performance. Investors may not get back the amount originally invested.
Of course, there is (probably) no connection whatsoever. They are just two lines that happen to be going down at the same time, with a few coincidental bumps along the way. Chart 3: Divorce rate in Maine correlates with per capita consumption or margarine
Source: tylervigen.com
Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.
Investment Newsletter May 2018
General Economic Overview The global economy continues to perform well. However, expectations have been too high and although the economic data is fine it has often been below forecasts. The UK economy had a very poor first quarter and as a result it seem unlikely that interest rates will go up much this year. Inflation is likely to come down given the stronger pound, however there is a great deal of uncertainty around this given the Brexit uncertainty. The oil price is also rising which could keep inflation higher. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Markets have rallied after the bout of volatility earlier this year. As a result they look more expensive again. We continue to see more value in Asia including China and Japan, and smaller companies within the UK.
-4
Fixed Interest Whilst we expect little in the way of rate increases in the UK they continue to rise in the US. Meanwhile the Fed is reversing quantitative easing. We don’t expect particularly spectacular returns but likely we believe the chance of substantial loss remains relatively low.
-4
Commercial Property We are positive about certain sectors of the property market and have positioned our portfolio accordingly. We still wish to avoid London offices and are also wary about retail. The score of -3 is based on our funds and if we scored the market as a whole it would likely be -5.
-3
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest, property and equity. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.
These represent EIM’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Brooke Court, Lower Meadow Road, Handforth Dean, Wilmslow, Cheshire SK9 3ND. Both companies are registered in England and Wales.