Financial Markets are Screaming Diversification- By Gabriel Mansueto

The positive sentiment which dominated financial markets since the beginning of the year persisted during the first three weeks of February as well. Risky assets, which include emerging markets, global equities and credit among others, where among the winners so far. This comes to no surprise – when investors are optimistic, risky assets are the main beneficiaries and as a result returns generated by higher risk assets usually dwarf returns on safer investments. The story is no different this time round. As at the time of writing, European equities as measured by the Euro Stoxx 50, are up just over 8% while the S&P500, in the US, has gained nearly 11% since the beginning of the year. Safer assets, such as the 10-year German Bund, have so far moved in the same direction to equities, but not with the same magnitude. In the US, the 10-year US Treasury has also started moving higher since mid-January.

In other words, investors are pouring money both in equities (high risk) and high quality sovereign bonds (low risk). It is not unusual that risky and good quality assets move in the same direction. Very often this was the case during the last decade, when central banks introduced quantitative easing to support economies and instil confidence. However, the situation is different now. Central banks’ intervention has reduced drastically in recent months and the fact that both asset classes are moving in the same direction is somewhat puzzling.

Why are the recent market moves confusing? Investors put more money in equities when the economy is expected to go through a positive trajectory and when risks to the global economy are outweighed by the expectations of positive data and strong fundamentals. On the other hand, investors put more money in to high quality assets when they fear volatility and a weak economic outlook.

Hence, investors putting more money in these assets, are less optimistic than the other group of investors who are buying into shares or equities. High quality sovereign bond investors are putting more money in these assets as a form of protection against a negative event. When such events occur, risky assets sell-off and high quality assets gain. In addition, the fact that interest rates are expected to remain low supports the view of investors buying into good quality debt. Conversely, if economic figures surprise and political tensions diminish, risky assets gain further as more money is poured in to equities and less in bonds.

Recent moves in emerging markets and some highly liquid currencies support the view of equity investors while gold’s rally since August last year is favouring bond investors’ views.

If we take emerging market equities as a proxy for risk, it is clear that equity investors are not simply upbeat on the US and the European economies but also on emerging markets. As a result, the MSCI Emerging Market Index, a composite of large and mid-cap companies across 24 countries, is up nearly 8% since the end of December. The same asset class lost just under 15% in 2018.

Moreover, the situation in currencies support the positive sentiment of equity investors. The Euro is not usually considered a safe haven currency and as a result it tends to move higher when investors are ready to take on more risk. The US Dollar, Swiss Franc and Japanese Yen have shown that they are investors’ favourite currencies during periods of heightened volatility. Since the beginning of the year, the Euro is stronger against all three currencies.

If we were to have a look at the price of gold as a proxy for safety, we find that since the beginning of the year gold is up 5% and 14% since mid-August 2018. The metal has features of a safe haven asset and tends to come in demand during times of fear. In fact, in the midst of the last financial crisis and the initial years that followed, investors found shelter in gold. It lost some of its shine as markets started to recover and risks to the global economy weakened.

While we recommend our clients to stick to their long term goals and veer away from the short term noise, it is natural to try understand why certain assets are behaving as such. Different investors’ views make up financial markets. Yet, having risky and safe assets moving in the same direction does raise questions. Who is wagering in the right direction is anyone’s guess.

As a result, in the current market environment, we cannot repeat the importance of diversification enough. While diversification can dampen returns in a rising market, our view is that markets will not trend higher uninterruptedly.

Investors should have a clear investment objective – whether income, growth or a mix of both. Anyone’s allocation across risky and safe assets should depend on the individual’s risk tolerance, investment objective and investment time horizon. There is no ideal portfolio that fits all risk profiles but in today’s market environment we feel the need to diversify more than ever. The recent market movements support further our view.

This article was prepared by Gabriel Mansueto, Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]

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