THIS year is far from over, although over the first nine months the financial markets have certainly delivered above-average excitement. It’s very different from the years before the Covid-19 crisis. During this period, all financial assets almost traded in value every day. It has been very pleasant, and for some investors it is a time of significant wealth creation, but the wind, in fact, has already changed.
Since the first quarter of this year, energy prices have risen, inflation has risen further and discussions are underway as to when major central banks will change course and move towards monetary tightening. These factors alone have rocked the bond markets on at least two occasions and increased the general level of fear among investors in the stock markets.
All of these factors mentioned have multiplied over the course of 2021, and that’s what I meant when I said that the tide (actually) has already changed. As always, the way forward in the financial markets is a jungle of many variables. One variable that I include is whether all asset classes in their price movements are mainly positively correlated or whether they will behave in a partially negative correlation. It might sound a bit intellectual, but with the way I approach asset allocation by mid-2023, this variable will have some significance.
One challenge many were aware of long before the Covid-19 crisis was that all financial assets were in an uptrend due to extreme quantitative monetary policy. The main effect was that the normal negative correlation between stock markets and bond markets reversed to become a positive one-way correlation. In normally functioning financial markets, investors would find that a positive stock market coexists with a bearish bond market and vice versa. The exciting challenge is what happens now, given the changing tide?
Central banks have attempted to counter the Covid-19 crisis by introducing even more extreme quantitative monetary policies. This is about to reverse and I expect investors to question whether the positive price correlation between all asset classes will persist if financial markets correct? Will all financial asset prices go down if a negative correction suddenly hits the financial markets, or could the normal negative correlation be back, so that it is possible to switch between different asset classes while getting a fair return on investment?
The first five years after the global financial crisis, when central banks introduced quantitative easing monetary policy, all financial assets began their positive price correlation and endless rise. If at that point central banks had reversed monetary policy, I have no doubt that all financial assets would have lost value, meaning that the positive price correlation worked in a downturn as well.
I will not claim that the price correlation was exactly as strong in the last few years before the Covid-19 crisis, although I will argue that to a large extent it was – for the same reason, overall. the financial world feared if the leader central banks would start to change monetary policy more than the US central bank.
When the Covid-19 crisis hit financial markets, it was across all asset classes, which might suggest that the positive price correlation was still intact. But in the event of a severe crisis, everyone in the world will naturally want to increase their cash reserves, which means that I don’t see last year’s March sell-off as representative in this correlation consideration.
But last month, the positive price correlation was obviously a factor, as all asset prices fell. If this continues then this is bad news as tactical investment decisions will receive a strong binary element. The consequence is that the investment decision is mainly to invest or place the money in cash. As long as the assets are held in cash, the return is close to zero or maybe even less than zero. Market volatility will also increase significantly as investors move in and out of all assets instead of switching between asset classes.
When I observe the different price movements over the past nine months, I argue that there has been increased diversification in price stocks. Local stock markets around the world have performed differently and among the different types of bonds, the differences in yield are noticeable.
This leads me to conclude that the financial markets are moving back to a less positive, if not negative, price correlation. This doesn’t particularly make life easier for investors, but it is a better life than a situation where it is the “fear level” that decides whether all asset prices go up or down – the good news is that it will go up. the hunt for the “right” investment decisions in 2022.