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The great escape The return to lower cross-asset correlations and fundamental investing

By Tracey McNaughton,
Head of Investment Strategy in Australia & New Zealand, UBS Asset Management

2017 marks the 10 year anniversary of the beginning of the Global Financial Crisis (GFC). Between February and March of that year, more than 25 sub-prime funds filed for bankruptcy opening the flood gates for many more. By August 2008, the interbank lending market froze and Britain experienced its first bank run since 1866.
Developed market central banks began cutting interest rates and financial markets collapsed. And so began the period of “lower for longer”.

In the following, we explain what lower for longer means from a portfolio construction point of view. As a starting point, we use modern portfolio theory as developed from Harry Markowitz. The chart below is known as the Capital Markets Line (CML). Beginning at the vertical axis with the risk-free cash rate, it shows how expected returns are built up from different risk premiums (liquidity, term, equity and credit). 

In the immediate aftermath of the GFC official interest rates were cut significantly around the world. This caused the CML line to shift progressively down, lowering expected returns as a result (illustrated by shift 1 in Chart 1). 

The introduction of quantitative easing (QE) forced investors to take more risk further out the risk spectrum. Risk premiums, the compensation for bearing uncertainty, volatility, illiquidity, and risk of extreme loss, were compressed as a result, and is illustrated by shift 2 in Chart 1.

Tracey McNaughton - Head of Investment Strategy in Australia & New Zealand

Tracey McNaughton was appointed Head of Investment Strategy in Australia & New Zealand in October 2013. In this role she has responsibility for Australian economic and investment research and is a member of the Australian Investment Committee.

How has lower for longer affected the functioning of financial markets?

By increasing the role and influence of central banks, overtly inserting them in the pricing function of financial assets, the lower for longer environment has had a significant effect on how financial markets operate. In addition to the compression of risk premiums already mentioned, below are some of the changes that have taken place in the lower for longer environment:

Higher correlations: Lower for longer raised correlations within and between asset classes. The blanket of liquidity laid over markets as a result of QE meant investor behaviour was primarily driven by a single factor – central bank financial engineering. This led to herd behavior in markets and over-crowded positioning that then became susceptible to violent corrections.

Chart 1: Capital Markets Line

A flattening of the CML line implies investors, in this lower for longer environment, were paid even less for the amount of risk taken

Chart 1: Capital Markets Line

Source: UBS. For illustrative purposes.

Fundamental investing taken a backseat: Like the witches of Macbeth, this was an environment where “fair is foul, and foul is fair” as bad economic news implied greater central bank support. Fundamental analysis was pushed aside and sentiment and momentum investing came to the fore.

Fatter tail risk: As Hyman Minsky, the famous US economist said, prolonged periods of economic stability breeds complacency, and complacency leads to excessive risk taking which ultimately leads to vulnerability. This vulnerability revealed itself in tail risk events whereby compressed premiums sprung leaving investors relying on central banks to step in and stabilize the market – which they did. 

Investment horizons shortened: The sidelining of fundamental analysis had an effect on trade design. Investment trade ideas within balanced portfolios became shorter in investment horizon and the unattractiveness of beta made relative value trades more common among multi-asset investors rather than outright directional position taking.

Traditional risk systems less reliable: The increase in correlations meant traditional risk systems could no longer be solely trusted to determine the amount of risk in a portfolio. Qualitative risk mapping whereby each trade in a portfolio was assessed on how it would perform under different scenarios and tail risk events became an important adjunct.

Chart 2: Alternative measures of inflation

Inflation in the ascent (alternative measures yoy%)

Chart 2: Alternative measures of inflation

Source: Bloomberg. As of end-February 2017.

Escaping from lower for longer requires the market to re-price three risks: duration risk, inflation risk, and higher potential growth risk.

The first step needed in escaping lower for longer is for risk premiums that were reduced as a result of QE to be priced back into asset markets. This would cause the CML to steepen and give investors more return for each additional unit of risk taken. Whilst QE ended in the US in December 2013, it was only after it was clear that expansionary fiscal policy was on its way, did the bond market begin to price it out by raising the term risk premium, the additional yield required to hold longer duration assets.

Inflation is moving higher across most developed market economies (Chart 2). This is in part due to the bottoming of oil prices, but even among core rates of inflation (ex food and energy), pressures are slowly creeping higher. By reducing its real value, higher inflation will help alleviate the constraint on growth caused by the build-up of debt levels in the post-crisis period.

The effect of higher inflation is to shift the CML line higher as conventional monetary policy kicks in with higher official interest rates.

Potential output growth is the maximum speed the economy can grow at before inflation begins to fire up. Over the past ten years or so, potential growth has declined across most developed markets. Given current interest rate settings in the US, a lower potential growth rate implies a lower neutral interest rate which implies a less expansionary monetary policy. The less expansionary monetary policy is the less stimulatory will it be for growth in the economy.

The effect of raising potential growth will be to shift the CML line higher (a reversal of shift 1 in Chart 1) as interest rates and monetary policy adjust to the associated increase in the neutral interest rate.

So what has driven the decline in potential growth? 

One way of discerning causes of the decline in potential growth, is to break down the long run economic growth trend into its five components (shown for the US in the table below).

In the last ten years, real GDP per person has averaged just 0.5% annually in the US. This compares to an average of 2.3% in the ten years prior.

Certainly demographics has had a role to play. The participation rate fell more over the last ten years than previously but the negative effect this had on trend growth (-0.4 ppts) was equally offset by the fact that people worked longer hours (+0.4 ppts).

Labor productivity was clearly the major driver of the decline in average growth having fallen from an average annual rate of 2.9% between 1996 and 2006 to an annual average of 1.2% in the last ten years. This component alone is responsible for 90% of the fall in growth per person, consistent with Paul Krugman’s claim that: “productivity isn’t everything, but in the long run it is almost everything.”

It is possible we are on the cusp of an uplift in productivity, we just don’t see it yet. Think of the hours spent developing autonomous vehicles, 3D printing, drone technology, electric cars, robotics, the internet of things, blockchain, or artificial intelligence. All have the potential to revolutionize the way we work in the economy unleashing a “fourth industrial revolution”.

Breakdown of the long run economic growth trend, US

Component of US GDP per capita (%)

1996-06

2006-16

Difference

Real GDP/Hours worked (labor productivity)

2.9

1.2

-1.7

Hours worked/Employed persons (average hours worked)

-0.8

-0.4

0.4

Employed persons/Labor force (employment rate)

0.2

0.1

-0.1

Labor force/Population aged 15 and over (participation rate)

-0.1

-0.5

-0.4

Population aged 15 and over/Population

0.2

0.2

0.0

Real GDP/Population

2.3

0.5

-1.8

Investment implications

For investors, escaping the environment of lower for longer means a reversal of influences that have been driving financial markets for almost a decade. That is, as we escape lower for longer we can expect:

  1. Risk premiums to rise back to pre-crisis levels
  2. Asset price correlations to fall
  3. Corporate and economic fundamental analysis to become a more important driver of markets over technical factors such as sentiment or momentum 

A full escape from lower for longer implies:

  1. A reduction in tail risk
  2. A lengthening of investment horizons as directional risk becomes clearer
  3. Traditional risk systems become more valid as correlations revert to historical norms

Conclusion

Just as it took several years for the environment of lower for longer to become as entrenched as it did, it will take many years for the market to escape it; not least because it will take time to repair the structural damage done to the economy in the meantime.

The process has begun however, the catalyst for the move was the election of Donald Trump as the new “tweeter-in-chief” in November 2016. Financial markets, being forward-looking, will start to adapt to life without financial engineering from central banks. In this environment, correlations will fall, fundamental value investing will reassert, and diversification opportunities will rise for multi-asset investors.