A golden age for balanced funds

Financial markets have seen a number of structural shifts in the past decade, according to Fidelity International. Equity markets around the world have become more correlated and where geography was once a key driver in asset allocation, now asset classes and industrial sectors also have a major influence on allocation decisions.

Speaking at a conference hosted by Fidelity International in London, Trevor Greetham, Director of Asset Allocation, commented: “Global investment strategy used to be all about picking the best countries in which to invest. Investors thought in terms of underweighting German equities to buy those in the US, for example. In recent years, this has been a less effective way of adding value as regional equity markets have become more highly correlated due to increased globalisation, the outsourcing movement, the launch of the Euro and highly synchronised economic cycles.”

“While thinking in terms of geography still helps, adopting a global sector strategy has become increasingly useful” continues Mr Greetham. “This is especially the case if fund managers can then identify the best stocks within each sector through international comparisons. The correlations between industrial sectors are relatively low and are likely to remain so given the fundamental differences between an oil company and a healthcare provider, for example. Meanwhile, individual companies increasingly compete on the global stage both in terms of their end product markets and the global capital flows they look to for funding.”

“While regional equity markets have become more highly correlated, the relationship between equities and bonds has done the reverse. The rolling five year correlation between U.S. stocks and bonds is at its most negative level for at least 106 years. The equivalent UK stock/bond correlation is at its most negative in for least 70 years.”

“Changes in the behaviour of inflation go a long way to explaining why this change has taken place and why low correlations between asset classes are likely to persist. During the inflationary 1970s and the twenty year disinflation trend that followed, equity and bond markets moved together, both suffering from and then benefiting from pronounced shifts in the interest rates investors used to value future cash flows. The Russia default crisis in September 1998 marked the start of a radical change; it was the first time in recent memory that the major central banks cut rates to prevent inflation becoming too low.

“Ever since, inflation has been low and well-contained with credible central bank arrangements in place to keep it that way. Nowadays, the differential performance of stocks and bonds is being driven by the economic growth cycle. During boom times, like the 1999 dot.com bubble or the last few years, equities have surged ahead while bonds suffered. During the synchronised global downturn of the early 2000s, equities were hit badly while bonds came into their own.”

Mr Greetham concluded, “All the time the two main asset classes moved together, diversification was treated with derision. It wasn’t until the dot.com bubble came to an end that investors started to appreciate the smoother returns to be gained from owning a mix of assets. As new asset classes such as commodities emerge and join the mainstream, the benefits of including these uncorrelated asset classes in a portfolio are also becoming evident. To my mind this is a golden age for balanced funds.”