- Last week’s US dollar strength subsided somewhat this week, but the USD has been quite strong over the last quarter. This has translated to poor performance across the board in Emerging markets over the same period – but in particular the non-Asian based emerging markets of the Americas and Europe. This is because much of Emerging Asia’s debt is no longer denominated in USD, so USD strength doesn’t really hurt them as much (in fact it makes their exports cheaper to Americans) – but regions such as Turkey and Egypt have large USD denominated debt burdens – so a strengthening dollar is disastrous for them
- In the last week most equity markets performed poorly, with Australia being a notable exception. In fact, over the last quarter both Europe and Australia have done very well compared to the rest of the world
- Friday of last week, was the official meeting of OPEC, prior to which both Saudi Arabia and Russia had indicated production increases were ‘inevitable’. The results of the meeting were that production increases will indeed occur. This is somewhat surprising since Iran is a member of OPEC, and any change in policy requires unanimous decisions – and Iran don’t want production increases. Increased production leads to lower prices, and due to sanctions enforced on them by the US they have limited partners to whom they can sell their oil, so they have less to sell at a potentially lower price
Portfolio Construction 101 – correlation
Anyone who has spent time learning the fundamentals of portfolio construction would be familiar with the concept of correlation, and the idea that less than perfectly correlated assets provide diversification and either a better return for the same risk, or less risk for the same return. For those lucky enough to have not spent much time thinking about it, correlation is simply a measure of how one or more assets move compared to each other. If you can find assets that both provide a positive return over time, but have a negative correlation when one performs particularly badly and a largely zero correlation at other times – that’s an ideal asset combination.
The foundation of multi-asset investing over the past few decades has been the idea that bonds act as negatively correlated assets to equities when equities sell off – in other words they go up in price when equities go down in price. If we look at the rolling 3 year correlation of the S&P 500 with the US 10 year Treasury index we can see this negative correlation:
This is the asset-allocation basis behind the majority of large Superannuation funds in Australia, endowments overseas and has worked really well for the last 20 years.
However, are bonds always negatively correlated with equities? Students of history would know that this isn’t the case. Unfortunately Bonds and equities can be positively correlated, and worse still, when they’re both going DOWN. We tested the correlation of Australian Bonds and equities back to 1885 (with the help of Milliman) to see how sound the theory was, with more than just 20 years’ worth of data – you can see the results below:
Future Potential Inflation
We are mentioning this now because global Central Banks have begun the process of either raising rates (the US and Canada) or easing/ceasing their Bond purchasing programs (ECB). This is because wage price inflation appears to be finally feeding through to the real economy and could feed through to prices. Central Bankers don’t want a repeat of the late 60’s leading to the inflation of the 70’s and the reaction required in the early 80’s. We are confident they have learned their lessons, but believe it is worth noting that in a rising rate environment, the building blocks of portfolio construction which have been broadly assumed by market participants for the last 20 years are unlikely to be best ones for the next 20. This is why DFS take a contrarian and evidence based approach to investing. We don’t just take assumed dependencies and rely on them ‘simply because’. We are constantly testing our thesis and looking for new ways to increase the robustness in our portfolio construction.
General Advice Warning
Past performance is not an indicator of future performance. The information provided in this article is general in nature and does not take into account your particular investment objectives, financial situation or insurance needs; we therefore recommend you seek advice tailored to your individual circumstances before making any specific decisions. Dobbrick Financial Services and its advisers are Authorised Representatives of Fortnum Private Wealth Ltd ABN 54 139 889 535 AFSL 357306. Dobbrick Financial Services are a Corporate Authorised Representative of Fortnum Private Wealth Ltd ABN 54 139 889 535 AFSL 357 306.