Market prices distorted by ultra-easy monetary policies and liquidity have resulted in rising correlation between stocks and bonds, according to Mark Haefele, UBS Wealth Management’s global CIO.
‘Correlations are now close to their highest levels in five years, making portfolios more vulnerable to increased short-term volatility,’ he said in his monthly investment newsletter.
'One investor response has been to seek safety in cash, with average investor proportions of it rising to 5.5% from 5.4% in the most recent BAML Global Fund Manager Survey.’
He said that for investors seeking higher returns than cash, but lower volatility, the investment team had developed two systematic approaches.
‘The first is our systematic hedging approach, which seeks low-cost downside protection on major equity markets by identifying cheaper hedges on less prominent but correlated indices.
'The second is our systematic allocation approach, which uses a proprietary equity market signal to dial up or down the equity exposure in a portfolio as deemed appropriate for market conditions,’ he said.
Diversify, diversify, diversify
For investors seeking diversification and returns in a world where bonds may be at risk of sharp drawdowns, Haefele believes alternatives – hedge funds and private markets – are worthy of allocations.
‘Hedge funds are unlikely to deliver the kind of returns they did before the financial crisis; the industry has expanded and competition for alpha is high. But they still provide effective portfolio diversification, and returns still compare favourably with other assets in a strategic allocation,’ he noted.
‘We expect hedge funds to generate annual returns of 5% over the next five years, for 6% expected annual volatility.’
‘Another solution to consider is our long-term investment themes, based on immutable trends such as population growth, urbanization, and aging,’ he added.
‘Attractive current themes include firms operating in the fields of safety and security, and companies focused on automation and robotics.
'As these themes include stocks or private assets that often don’t feature in mainstream benchmarks, they can increase diversification benefits.’
Over the short term, Haefele said he maintains a positive view on risky assets.
‘Loose policy and earnings growth should offset potential risks, and we are staying overweight equities relative to bonds in our global tactical asset allocations.'
He said his team is overweight US equities against high grade bonds because they are less expensive, less vulnerable, and have greater upside potential.
‘We are overweight emerging market equites versus Swiss equities,' he added.
‘Profits are starting to stabilise in emerging countries after a multi-year malaise. The turnaround should be fuelled by reviving economic momentum.’