Correlations show us how assets have moved relative to each other in the past. As multi-asset investors, one of our key objectives is to identify assets that improve diversification. To do this, we try to combine assets with low or even negative correlations. This sounds easy, but can be surprisingly difficult in reality.
US inflation was lacklustre in 2017, despite falling unemployment. This combination was very supportive for equities. In 2018, a key risk is that we see a similar wage pick-up in the US to what we’ve already seen in Central and Eastern Europe, where labour markets are also tight. As a result, we believe there are potential benefits in holding US dollar and US inflation exposure in portfolios to help mitigate the risk of higher interest rates undermining equities and other risk assets.
‘Less is more!’ That is what correlation wants to brag about to enhance diversification. However, following the financial crisis, many believe that correlations are at an all-time high – is this the end of low correlations? We think not.
History is littered with episodes where the rules of economics were declared dead, only for these rules to return with a vengeance. You remember the ‘end of the business cycle’ debate in the late 90s or the ‘great moderation’ paradigm of the early 00s? Despite these precedents and despite overwhelming evidence that large debt build-ups can end in tears, we believe a Chinese financial crisis is not that likely over the next 2-3 years.
A great advantage in managing money is having the ability to wait: avoiding a situation where you have to invest. This means you can pass on an investment idea simply because it doesn’t look interesting enough and wait for truly great opportunities. American baseball fans call this “waiting for the fat pitch”.