What The Fed Pivot Means For Asset Class Correlation

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Janus Henderson Investors
Summary

Central banks have shifted their policies to be more accommodative, causing stocks and bonds to move up.

A couple of scenarios could result from this shift in stance – the worst-case scenario being that stocks and bonds both fall together.

We believe a focus on diversification is more important than ever in this environment, but caution that investors should be aware of how different types of strategies are correlated with the market.

By Leah Reed

As the Federal Reserve (Fed) has shifted its policy to be more accommodative, both stocks and bonds have generated exaggerated returns. Depending on the reason for the Fed's pivot, different scenarios could unfold. In light of this uncertainty, Leah Reed, Financial Engineer for Diversified Alternatives, believes investors should be especially mindful of diversification, paying close attention to correlation.

Transcript

Leah Reed: Central banks have shifted policy to be more accommodative, which has really caused stocks and bonds to move up. We've seen these exaggerated returns in stocks and bonds, we've hit new equity highs.

So I think the real question is, why such a pivot by the Fed? First, it might be that the Fed sees some troubling economic data or trends in the data that would warrant greater accommodation. Or you could have the situation that they're willing to keep the monetary supply expansive in order to ignite inflation. But even given that, and the uncertainty of both of those, it's unlikely that both equities and fixed income will continue to rise together because they're such two different scenarios. So if the Fed is successful in igniting inflation, then likely you're going to see interest rates rise and then bonds are going to have a difficult time. And if there's some kind of unstable part of the economy, then you're going to see some difficulty or headwinds for equities. But I think the worst scenario is that we've seen stocks and bonds both go up, if they happen to both go down together. And that's why we feel that it's really important for investors to focus on diversification.

There's a slight negative correlation between fixed income and equities and commodities and a slight positive correlation between equities and commodities. So the correlations are very low, and we're almost in this Goldilocks type of regime where you have stocks and bonds going up, volatility is low, correlations are low. But to us, that means that we should be a little bit more cautious about being in the market.

So we like to look at different types of opportunities or strategies in the market that could give a return, especially during stress periods when vol [volatility] shoots up and correlations rise. That's typically what happens in those types of stress periods. So the type of strategies we like to look at are strategies that can be both long and short. So trend following strategies, for example, allow investors to capitalize on persistent trends in the market. So if inflation and rates start to go up, then the portfolio could engage in a short bond position.

And then there are opportunities in other asset classes as well, like commodities. There's more to commodities than just being long the commodity index. There are ways to be both long and short in that market, and there are things outside economic factors like the weather that can give opportunities to trade and generate a return from those markets.

And then even currencies. You can look at rate differentials and be both long and short for different currencies. So there are a number of different opportunities across asset classes that can be uncorrelated. But I would tell investors to be very careful about the ties those strategies have to the market, their correlations and their betas to the market.

The opinions and views expressed are as of the date published and are subject to change without notice. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes and are not an indication of trading intent. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Janus Henderson Group plc through its subsidiaries may manage investment products with a financial interest in securities mentioned herein and any comments should not be construed as a reflection on the past or future profitability. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Equity and fixed income securities are subject to various risks including, but not limited to, market risk, credit risk and interest rate risk.
Alternative investments include, but are not limited to, commodities, real estate, currencies, hedging strategies, futures, structured products, and other securities intended to be less correlated to the market. They are typically subject to increased risk and are not suitable for all investors.
Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.

There are special risks associated with selling securities short. Stocks sold short have the potential risk of unlimited losses.
An index is unmanaged and not available for direct investment.

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C-0519-24074 05-30-20

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