Financial Markets

When non-correlated assets come back to haunt you

Originally published in the March 2008 issue

As we emerge from the wreckage of the credit carry trade and the tremendous flight to safety rally in bonds, it looks like the next move is the reflation trade, converting cheap fed funds into leveraged bets on real assets in general and commodities in particular. Seeing multi-year highs for metals, coal and oil while bond prices were also soaring presented something of a problem for those clinging to a belief system requiring all market moves to be explained in terms of a US GDP forecast. Either bonds were right that there was a recession coming or commodities were right that there was excess global demand.

We have of course seen such apparent conundrums before, but this is only a puzzle if we fall into the common trap of confusing market prices with demand and supply conditions in the real world. In fact it is perfectly rational to buy both bonds and commodities if you look at them in the context of market mechanics rather than global economics.

Reading the signs

The interaction between the credit cycle and broader economic activity has altered radically over the last 25 years, something that the econometricians and market historians tend to rather overlook. The securitization boom of the 1990s that has ultimately given us the credit crisis has had a number of profound effects on the interaction between economies and financial markets along the way, all of which are extremely important for investors.

For example, the development of the fixed rate refinaceable mortgage market in the US following the 1990 savings and loans crisis meant that within a decade as much as three quarters of all US mortgages were fixed for between 15 and 30 years. Economic models based on the yield curve generally fail to acknowledge this such that they continue to see higher short term interest rates as hitting the ‘over-leveraged US consumer’ when in fact the overwhelming majority have no cash flow effects at all.

Similarly with corporate debt, securitization effectively changed the sensitivity of the corporate sector to changes in official interest rates. The flip side of all this of course is that the sector that is really dependent on the credit cycle is the financial sector itself; carry trades have become an end in themselves and the view that there is always a carry trade going on somewhere is well founded. It is just that we don’t always notice them until they unwind.

The fact that a number of seemingly different asset classes can appear to become correlated – in the way commodities and bonds have been until lately – and then un-correlated just as quickly is not only confusing to those seeking an economic rationale to every twist and turn in markets. It also has implications for traders and investors.

To recognise that the key driver to the bond market is the arbitrage on the curve rather than the inflation rate is important for investors in other asset classes else they risk investing in their own markets on a misinterpretation of the noise in fixed income. For example, the monthly non-farm payroll number offers little real insight to an equity investor but it is currently an important part of the tail risk facing him. Bond investors are both trying to predict and trying to ‘Game’ the Fed into delivering them arbitrage profits by cutting funds rates.

“The securitization boom of the 1990s that has ultimately given us the credit crisis has had a number of profound effects”

The apocalyptic prose they employ is relatively harmless in the context of their own markets but can have alarming spill over effects. Here it is also important to recognise the difference between the interest rate arbitrageurs and the noise traders or momentum investors. This group will amplify the noise in any direction in any market if they can find a trend; and the longer the trend goes on the greater their role. And as is the way of markets, the longer they have been ‘right’ the more money they get given to play with and the more they seem to call the market. Until of course one of two things happens, the actual fundamentals re-assert themselves or the leverage and liquidity gets taken out of the market by a shift in the credit cycle.

True multi-asset funds can, and I suspect do, make good profits from being speculators rather than investors. Finding whatever asset class has momentum and joining in can be extremely lucrative so long as you are neither too greedy nor make the mistake of thinking you are a fundamental investor. Single asset funds meanwhile need to be extremely aware of when the speculators are running their market. Their biggest danger is not to suspend the disbelief in their own market fundamentals, but to adopt a new belief system.

Logic isn’t always correct

So what does this mean for the equity investor? First off, don’t make your stock selection on the basis of the justification economics coming out of the arbitrageurs and noise traders. A belief that there was a recession and lower interest rates coming that left you short mining and energy stocks and long property and financials would have been just about the worst sector construction possible. But it would have been logical. Equally while the current explosion in commodity prices might undermine the case for global recession, it does not signal the huge inflation that the noise traders are starting to talk about, sensing as they do a turning point in bond markets. What this does mean however is that certain industries are going to face very real margin squeezes.

The fact that the speculators are hedging their $ exposure means either that the $ goes down because commodities go up or the other way around. You choose, depends which market report you read. But they will be inversely correlated. For now. While concern about the US economy might be the root cause of the desire to hedge, a weak $ of itself does not justify a forecast of a weak US economy. On a related issue, note how the noise said everything in the UK economy was great as long as sterling was going up; it took a cut in rates and a reversal of a momentum trade for the bearish fundamentals to suddenly be ‘noticed’.

Second, decide how and whether you can hedge the tail risk to your portfolio generated by all this external activity. In essence this is the implicit thinking in market neutral hedge funds, focus on pure stock selection and effectively strip out the market noise – remove the exogenous risk. More directional funds need to think of another way. Derivative overlays certainly help, but are relatively expensive.

Diversification is also a good idea in theory, but as the last year has shown, non correlated assets have an unpleasant habit of becoming highly correlated just when you need them not to be. In my view quasi directional investors need to be pragmatic. Respect the capacity of other markets to impose volatility upon yours and if they start to impose false fundamentals look for an opportunity to take them on where you have knowledge. But remember the words of J M Keynes, himself a speculator rather than an investor: markets can remain irrational longer than you can remain solvent.

Mark Tinker is Fund Manager of the AXA Framlington Absolute Return Gemini Fund