Risk and correlation

The covariance matrix

Risk and correlation plays an important role in portfolio construction. We use a factor approach to build our covariance matrix. This approach produces an internally consistent covariance matrix with fewer assumptions than needed for directly estimating volatilities and pair-wise correlations. 1

We expect equity market volatility generally to increase from the low levels seen prior to the fourth quarter of 2018. After spiking with the GFC, volatility declined substantially into 2017. As seen the in the next chart, equity volatility reached mid-single digit ranges and has started to rapidly increase. We would not be surprised to see further increases in the short run as trade issues and geopolitical risks remain elevated. We also note the realized volatility of the 10-year Treasury return is below its average and we expect this to become more elevated in the future.

Historic volatility: 1997-2019 - S&P 500 and 10-yr Treasury S&P 500 and 10-year Treasury

Source: S&P, Bloomberg Barclays, Morningstar Direct. Data as of 30 June 2019.

Historic stock-bond correlation: 1997-2019

Source: S&P, Bloomberg Barclays, Morningstar Direct. Data as of 30 June 2019.

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