Correlation and hedge

A broad portfolio of most uncorrelated assets is the recipe for long-term high risk-adjusted returns, and during periods of weak stock markets, a hedge becomes all the more important in order to avoid strong downturns. But how should one think during periods when assets that normally have low or no correlation, suddenly collapse simultaneously?

The year started strong for commodities but weak for equities. So far this year, the S&P 500 has fallen almost 20 percent, while the oil price initially rose sharply to later trade sideways until a couple of weeks ago, when the price - despite fundamental factors such as an imbalance between supply and demand points to a continued rise - suddenly fell from over 120 USD to today trading around 108 USD per barrel. Agricultural raw materials also rose initially, but even since a peak in mid-April, they have fallen by more than 10 percent.

Despite the fact that assets are traded over time with low correlation, that relationship tends to change during major market events - and right now we are in one. With rising interest rates and a recession around the corner, where the Federal Reserve has completely turned from dove-like policies to hawkish ones, it is difficult to find short-term protection. For those who previously got used to buying the dip in shares, the first half of the year has meant a sad awakening.

With inflation as the top priority for the Federal Reserve, we can expect future Quantitative Easings to be absent. Instead, it will be more important to keep an eye on how consumer prices develop in the future. During the 1970s, which is the easiest period of time to compare the 2020s with, inflation rose in waves for a decade, before then-Fed chief Paul Volcker finally overcame the problem by raising interest rates to 20 percent in 1980.

It is likely that Jerome Powell will continue to raise interest rates into a recession, and that the recession itself will contribute to inflation appearing to be under control. This, in turn, would lead to a pause in the austerity cycle, and depending on how bad the US economy looks then, possibly an interest rate cut - not entirely unlike the way Volcker acted in 1972-1982.

When we saw stagflation in the 1970s, it was mainly physical commodities that outperformed in the long term, while the stock market was relatively weak throughout the decade. If we are at the beginning of a similar decade, there is still an upside (with volatility) in commodities, and an even bigger downside than the one we have already seen in equities.

Rising interest rates, high inflation and a recession will put pressure on both profit margins and growth forecasts for equities in the future, and although the beginning of the year so far may have felt infinitely long for those who have not experienced downtime beyond the initial covid crash, this is probably just the beginning.