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Correlation streak

Professional investors are a binary breed. They may talk a good game about portfolio diversification but their existence is apparently and curiously devoid of grey. Active or passive, developed world or emerging markets, growth or income, big comp-anies or small, value or growth, stocks or bonds – for them, third ways and middle grounds are best left to politicians.

It should therefore not come as too much of a surprise to learn a new investment phenomenon has been catching the attention of investment academics and commentators. This is the growing correlation between assets, which has become evident in a school of invest-ment thinking that could well have been invented by Mr Miyagi in The Karate Kid – “Risk on, risk off”.

Even if you didn’t know its name, you will have grown instinctively aware of the idea over the course of the last few years. One day, investors will survey a list of known market considerations, say, the risk of sovereign defaults, the chances of queasing and the prospects of a double-dip – fancy their chances and conc-lude it is time to go “risk on”.

With the irrepressibility of toddlers on Sunny Delight, they will morph into their superhero other selves through the time-honoured practice of wearing their duffel coat like a cloak and pile into risk assets such as emerging markets equities.

Soon, however, they will survey a different list of known market considerations, say, the prospects of a double-dip, the chances of queasing and the risk of sovereign defaults – and take fright. Suitably “risk off”, their duffel coats lying in a heap in the corner, they will shelter in their fort under the kitchen table, nursing their Sunny Delight come-downs and piling into government bonds.

This causes problems for the active manager, who finds his efforts unrewarded by a market no longer able to distinguish between good and bad. This in turn leads to journalists – another breed partial to an extreme or three – writing solemnly on the death of stockpicking. (Coming soon to a newspaper near you: Why stockpicking’s great.)

I may return another week to the growing number of theories for the increase in correlation but for now let us focus on a recent pronounce-ment from the not-very-extreme-at-all Schroders chief economist Keith Wade.

He says: “Recognising currency wars are likely to continue suggests we could be in for a turbulent time. The US is already preparing protectionist measures that will be wending their way through Congress. Countries that are seen to deliberately run a policy of keeping their exchange rate undervalued are to be targeted. Rhetoric could turn ugly and tensions are likely to mount as countries pursue “beggar my-neighbour” policies.

“Meanwhile, we are likely to see continued capital flows to the emerging markets as interest rates in the West remain close to zero and the US restarts quantitative easing. In the absence of a shift in policy, the outcome will be more intervention and a recycling of the capital flows back into the US Treasury market. This in turn depresses long rates and forces more capital outflows as investors seek yield. The result could be a simultaneous bubble in both Treasury bonds and emerging market equities.”

Two thought occur from this. First, practitioners of the art of risk on, risk off might like to start considering adding a third notch to their investing dial and, second, I may have overlooked something in my previous discourses on bubbles.

My theory has always been that, hard as investors, commentators and journalists may try, any attempt on their part to flag up a bubble in advance is doomed to failure because the very act of flagging up will deflate the bubble – at least until such a time as nobody is watching any more and the bubble can do what bubbles do best.

Yet Mr Wade’s cunning “double bubble” scenario is one that ordains investors will be caught out once, maybe even twice – and yet, despite his warning, this is inevitably going to happen. Like the scorpion stinging the frog that is carrying it across a river, thereby signing its own death warrant too – it is in these investors’ nature.

Julian Marr is editorial director of and


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