Thursday, May 3rd, 2018

Few places to hide

Last week, we argued that it was time to worry about oil. We believe that Brent has broken out of the trading range it has been it since 2015, even if we allow for last year’s weakness in the dollar. It is possible that the top of the new trading range could be anywhere between $85-100/bbl but attempting to forecast this with precision is a fool’s errand. It is simpler and more effective to treat this as a risk-scenario and work what effect it might have on our portfolio. The best way is to look at two sets of correlations: first between equities and bonds; second between oil futures and a balanced 50/50 portfolio.

Most asset allocation processes are founded on the idea that returns from bonds and equities are negatively correlated. It’s not always true. For most of the late 1990’s, they were positively correlated, but because both were rising strongly nobody minded. Since 2001, the 52-week correlation between US Treasuries and US Equities has been negative for most of the time, apart from two episodes in late 2006 and early 2014. Recent data suggest that we may be due another of these episodes, with the latest reading at just 0.09. This says nothing about direction, but it’s possible that both asset classes could fall at the same time, which investors definitely would care about.

Given the growth of US shale output, it’s doubtful whether an oil shock would be large enough, on its own, to cause a sustained fall in both asset classes. However, in combination with an unrelated development – say, a Tech wobble in China and the US – it could be enough to depress the performance of a balanced portfolio of US assets and boost the attraction of oil futures. The current correlation is slightly above the 52-week median since 1995, which is positive, but close to zero. However, for most of 2017 it was negative and it has recently started to move back in that direction. None of this is conclusive proof that a direct investment in oil futures is required, but if investors are already overweight in Energy equities and US High Yield, it may be the next logical step.

The situation changes when we cross into Europe. For Eurozone investors, the correlation between equities and bonds has ranged between zero and -0.20 for most of the last five years. We are at the top end of this but it would require a significant change for us to be concerned that equities and bonds could both fall at the same time. The Draghi put is still operating, which means that investors don’t really need an oil hedge.

For sterling investors, the situation is not so benign. The correlation between equities and bonds is now +0.27, the highest level since 2001. It has been trending higher since June 2016, which may be one of the most important, and least referred to, effects of Brexit. There is a significant and rising risk that UK Equities and Gilts could both fall at the same time. The case for non-conventional assets is stronger than elsewhere, but it is not clear whether oil is the right option. The correlation between oil futures (with no currency hedge) and a balanced portfolio is in line with its historic median, and trending sideways. The danger with waiting until it has moved is that oil may be a lot higher and UK assets a lot lower.

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