One week / one topic: Kaleidoscopes

What happened?

Central bank independence – what a quaint notion! – seems to be on its way out.

As President Trump is busy running the TV show also known as “The Apprentice – Federal Reserve edition” with all its hiring, firing and other media-friendly drama, investors are left to ponder the potential implications.

But do people even care, with so many other crises everywhere you look? Or, is the possible advent of AGI all that matters at this stage?

Thankfully (…), the trade tariff announcements from April 2nd provide a relevant data point to grapple with questions about the importance of policy. Let’s take a look.

Below is the rolling 12m correlation between Equities and Government bonds for the US, Germany, Japan and the UK.

Its importance can hardly be overstated as the main pillar of Modern Portfolio Theory, and of course as the principal argument for asset class diversification and the ubiquitous 60/40 portfolio.

In simple terms, if equities and bonds both produce positive returns and zig when the other one zags… you’re good.

Without forgetting all the usual caveats of course, we can use also the following rule of thumb to interpret the charts below:

• Positive stocks/bonds correlation -> The market is concerned about inflation (i.e. the 1990s and the post-Covid 2022-2024 phase)

• Negative stocks/bonds correlation -> The market is concerned about deflation (i.e. the aftermath of the Dot Com bubble, or the post-GFC decade)

When it comes the US, the tariff announcements coincided with a huge flip in correlations as markets suddenly worried about the impact of what is in effect a tax on consumers.

Interestingly, dire forecasts have failed to materialize since – and a politicized Fed might well keep rates low enough and for long enough to cushion the blow.

No surprise then that “short Dollar” is a consensus trade… As for US Treasuries, let’s just say that the jury is still out.

Germany followed a similar path, but the announcement came of course just weeks after a major sea change in its fiscal doctrine, with huge implications for domestic investment and rearmament efforts.

Having a massive trade surplus with the US makes for an easy target, and – as we have observed since – we are very much in a “might makes right” environment.

A significantly lower fiscal burden and a widening gap between how the ECB and the Fed are run also mean that Bunds can perhaps be trusted more to provide portfolio insurance when you (will inevitably) need it.

Japan historically tends to be on a different wavelength, but – despite meaningful ongoing developments on the political, fiscal and monetary fronts – the flip in correlation is very visible.

Furthermore, the time series below recently approached both its historical highs and lows in the space of a few months.

Markets seem to think that structural change is afoot, and there might well more to come in terms of significant domestic policy twists and turns.

Finally, there is the peculiar case of the United Kingdom. While the sharp drop in stocks/bonds correlation is clearly visible around April 2nd, the event failed to send it to a negative level – unlike the other countries examined above.

Aided also by a much smaller trade imbalance between the US and the UK – which resulted in one of the lowest tariff levels imposed so far – markets apparently think that the country’s troubled fiscal situation matters a great deal more, especially as inflation remains stubbornly high.

Put differently, domestic policy concerns remain central.

So, what can we conclude from the above observations?

1. Evidently, policy matters… a lot

2. In an era of fiscal dominance, the impact of policy announcements is exacerbated.

But what are the implications for portfolios today? Is there signal beyond the noise?

Our observations

• Fundamentals: While it’s tempting to conclude that guessing policy announcements in advance is all that matters, it is simply not doable. Better then to stick with a diversified approach looking for a margin of safety, if you can at all find it.

• Price action: Trump 2.0 can very much move markets, but there is a constraint in the form of US Treasury yields. However, reflexivity kicked in around 4.50% on 10yr yields back in April, so there is some wiggle room for more noise given that we are at ~4.20% now.

• Investor beliefs: When even Howard Marks says we might be only “in the early days of a bubble”, it’s reasonable to question whether AI stocks have much further to run despite expensive valuations?

So what?

For all its flaws, Modern Portfolio Theory still has its uses and indeed diversification remains paramount.

Since the AI steamroller seems unstoppable for now, then where else in portfolios can we attempt to harness its benefits?

Using as a guide the rolling 12m correlation (i.e. the same measure used above) between a selection of emerging markets (EM) equity indices and the S&P 500 (all in common currency terms), we can observe the following:

• All the EM equity markets below have become less correlated to the US market over the last few months.

• Similarly, they are all less correlated to US markets than they have been historically.

Of course, there are other important considerations.

First of all, EM assets tend to respond to changing views about ‘country risk’ much more than their Developed Markets (DM) counterparts.

In other words, the equities, bonds and currency of any single EM country usually move much more together than they do for DMs – so you’re not fully comparing apples to apples, as you are taking on ‘country risk’ and not only ‘equities risk’.

Secondly, the recent period of declining correlations has not really been tested by a global, systemic risk event.

In a true crisis, you might well see that risk assets all go down at the same time… once again.

That said, everything else equal, you should still be more inclined to own assets that are less correlated to help mitigate the infamous “volatility tax”.

With the above in mind – and as we remain quite concerned about the continued vagaries of US policymaking – the allure of EM equities and their supposedly uncorrelated nature then shines bright.

To boot, EM valuations look remarkably more attractive, providing the (illusion of?) an additional margin of safety on top of the diversification benefits.

Putting it all together, we are then inclined to further rotate away from developed market equities (Europe, I am looking at you) in favor of EM.

Mood music: Marvin Gaye – What’s Going On