Monday, October 31, 2016

What scares any asset allocator - Correlated markets

October was a rough performance months for investors. Risk-off could be the best explanation; however, the reality of the Fed raising rates by the end of year seems to be sinking into the expectations of all investors. There was no protection from holding the long bond with a decline of over four percent. What is our biggest concern is the correlation between stocks and bonds for the month. There was no diversification gain.

Clearly, the desire to hold less long exposure has become the driver in fixed income with new talk that inflation is around the corner. Yes, inflation has increased and is closing in on the magic 2% target but there is little sense that inflation will overshoot regardless of some comments by Fed officials that this could be desirable. While equities are supposed to be protected from inflation, an inflation shock may be disruptive to both asset classes in the short-run.

The biggest losers were small cap stocks both value and growth. In a rising rate market with limited growth, small caps are usually hit harder from the effect of leverage and sensitivity to top-line revenue growth. Emerging markets both stocks and bonds behaved like a safe haven. DM stocks as measured by the MSCI world index fell more than large cap US stocks. Global DM bonds fell to the same degree as US bonds. The only safe places for investors were mortgages which have shorter duration and limited credit risk and commodities which saw a bump in prices outside of the energy complex. 

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