Cash is king as correlations cloud asset allocation

LONDON (Reuters) - Stocks and bonds are moving in lock-step more than at any time since the financial crisis, making life difficult for asset allocators and driving investors into the one asset guaranteed to bring zero return - cash.

A picture illustration of crumpled kuna, Dollar and euro banknotes, taken in Zagreb January 18, 2011. REUTERS/Nikola Solic

Years of ultra-loose monetary policy and asset-buying stimulus programs have driven up equity valuations, despite tepid earnings growth, and created such demand for bonds that investors are prepared to pay countries and companies to borrow.

Over a rolling two-year period, the positive correlation between stocks and bonds, which usually move in opposite directions, is at its highest levels since the financial crisis, according to Thomson Reuters data.

This was illustrated weeks ago after the European Central Bank did not extend its asset-purchase program, confounding expectations of many market participants. Stocks and bonds fell sharply across the globe in a sell-off that lasted several days.

Such moves are not ideal for investors, who can face sharp shifts in their portfolios as assets rise or fall together, or for money managers who need to generate return consistently.

What both want are assets that go up as others go down - a negative correlation.

“For the moment that negative correlation, which is what you want as an investor, has gone,” said Rory McPherson, head of investment strategy at Psigma Investment Management.

In response, investors are keeping near-record levels of cash. The latest Bank of America Merrill Lynch survey of global fund managers found cash made up 5.5 percent of portfolios.

Psigma’s McPherson has taken the average client’s cash levels to 7 percent, an all time high, while waiting for any opportunities created if prices continue to fall.

What September’s sell-off may illustrate is that the industry-standard “60/40 model” – where a fund manager holds a portfolio of 60 percent stocks and 40 percent bonds – can no longer protect against volatility in all scenarios.

These so-called “balanced” funds have suffered in a time of rising correlations, according to strategists at Goldman Sachs.

“If you look at returns over time, 60/40 has been a great product,” said Roger Sadewsky, director of multi-asset investing at Standard Life Investments. “[But] mathematically, we are all aware you have to assume government bonds must keep going negative for that to work as a strategy.”

Instead, investors have to look more closely at individual corners of the market for uncorrelated returns.

Finding those opportunities has become “the holy grail” for multi-asset investors, said Ana Cuddeford of M&G Investments.

“The last few days are a case in point,” she said. “It is extremely difficult and makes the environment a lot more challenging.

“We are trying to make sure our portfolios are constructed to find assets that are least correlated.”


Those assets will differ depending on whether investors see the recent sell-off as the start of a trend or a short-term blip – a “head fake”, as Sadewsky called it.

In a world where bonds fall, potentially taking stocks with them, banks may be one of the few sectors that would do well given they benefit from higher bond yields.

M&G’s multi-asset portfolio has one of its highest conviction positions in Japanese banks, that tend to be uncorrelated with many other assets, said Cuddeford. McPherson too has positioned portfolios in more cyclical sectors like banks and commodities.

In Europe, there is broader evidence of this trend: Bank of America said some fund managers have deployed cash to cover their underweight positions in financials and commodities in September.

Banks outperformed the broader index during similar market conditions – the 2013 “taper tantrum” when U.S. Treasury yields surged as the Federal Reserve began to reduce the amount of money it was pumping into the economy, and a period in 2015 when stocks and bonds fell.

But they have struggled with profitability and regulatory issues, particularly in Europe – and anyway, are unlikely to generate positive returns in volatile markets, McPherson said.

More esoteric strategies can also help. Sadewsky said relative value strategies, that involve playing off markets against each other, can provide uncorrelated returns, although they tend to only be available to more sophisticated investors.

For many investors, cash is still king.

“If the moves are as sharp as they have been, both stocks and bonds will suffer, McPherson said. “It’s why we have a lot of cash.”

Reporting by Alasdair Pal; Editing by Toby Chopra