Right, so one of the dangerous things about markets where shit is demonstrating a disconcerting propensity to sell off simultaneously is that there’s no diversification.
Over the past two weeks, the CTA/ risk parity unwind has heightened concerns about the extent to which we can depend on the diversification benefits of allocating across multiple asset classes – specifically, stocks and bonds.
You’ll recall what Goldman wrote late last month in a sprawling report on the low vol. regime:
In multi-asset portfolios, investors might face further risk based on the premise of diversification. Absolute cross-asset correlations tend to increase with higher volatility (Exhibit 39). This is especially a risk for risk parity funds and volatility target funds which often increase risk based on volatility by asset class and on a portfolio level.
Since the 1990s bonds have provided hedges for equities in periods of higher volatility, allowing multi-asset investors to run higher risk/leverage levels. But right now, as both bonds and equities appear expensive, bonds may be less good hedges for equities in drawdowns, and there is the potential for negative rate shocks to weigh on equities, as central banks tighten policy. Commodities have helped in high inflation periods like the 1970s but they have been more a source of risk recently, with large oil price declines and still-low inflation.
That’s left quite a few people pondering the rather uncomfortable proposition of going to cash, which is exactly what Goldman recommended in that same note. To wit:
This further strengthens the case for increased cash allocations and also for broader diversification.
Well on Wednesday, BofAML’s Research Investment Committee is out echoing the sentiment that it’s probably time to raise your cash allocation.
“Bank of America Merrill Lynch’s Research Investment Committee recommends reducing stock allocations in favor of cash,” Bloomberg wrote this morning, adding that “the advice comes as the S&P 500 approaches the committee’s year-end target amid slowing earnings growth, high valuations and a tightening Fed.”
“We recommend that investors lock in some gains in the stock market, re-balance to under-owned sectors and hold above-average cash,” Martin Mauro and his posse wrote in the note accompanying the recommendation. Here are some other details:
- Stock allocation in U.S. moderate risk profile cut to 56 percent from 58 percent, cash position raised to 6 percent from 4 percent
- Small-cap value and emerging market stocks both shift to equal-weight from overweight
- Small-caps were expected to benefit from pro-growth Trump policies; likelihood of tax reform passing this year now diminished: strategists
Increased cash allocation due to committee’s view Fed will raise rates once more in 2017 and three times in 2018
- Committee doesn’t recommend increasing exposure to bonds yet, expects yields to rise over remainder of year
There’s only one problem with this…