Two Asset Classes in Times of Turmoil: Risky and Risk-Free

by: TradingHelpDesk

We are in truly unique times. The depression of the 1930’s shares the most traits with the current recession. Both periods suffered systematic failures, rather than just being ‘bubble’ recessions, but there are key differences. Over the past 75 years, financial instruments have increased exponentially both in terms of their complexity and breadth of international distribution. Risky assets such as equities, corporate bonds, property, commodities, higher yielding currencies and the infinite number of alternative investments were previously thought to offer strong diversification benefits, when combined, through all stages of the economic cycle. The past year has proved that theory wrong.

The correlation (similarity in performance and volatility) of all risky assets increases substantially in periods of systematic stress. It always has. Also the correlation of risky assets has increased generally since the mid 1990’s, through all stages of the economic cycle due to globalization and the ability to trade any asset class online from any location. The efficient circulation of information also means buyers and sellers can act simultaneously, creating additional momentum in price volatility across all markets.

Add into this high-correlation equation the lack of liquidity suffered by investors in times of turmoil, particularly those exposed to more exotic instruments previously marketed as having absolute return characteristics, and I would suggest in times of recession and economic turmoil, there are not a plethora of asset classes, there are two: risk free assets and all risky assets. If you really pressed, I would be sympathetic to the view that gold can represent a third asset class in such times.

I would also suggest future recessions are inevitable. Governments and central banks are committed to using monetary policy as the primary tool to stimulate or cool down the economy. This blunt instrument distorts the nominal supply of money relative to the real economic wealth of society. During periods of monetary easing, a large proportion of this excess supply of money is consistently misallocated to consumption and financial transactions. Inflation and asset price bubbles are the result. Higher interest rates follow, confidence weakens, demand falls, prices collapse, liquidity fades and the circle of boom-bust remains intact.

In summary:

  1. The performance characteristics of constituents within risky asset portfolios are increasing in correlation over time.
  2. That correlation jumps higher when the benefits of diversification are most needed, in times of market turmoil.
  3. Traditional diversification techniques used today do not work.
  4. We will suffer more recessions and renewed market turmoil in the future.

Is it fair to conclude the current framework of the investment industry is therefore flawed?