Tower: Beating back the bear

The global credit crunch has driven many asset classes into bear markets as confidence has fallen and finance dried up. The latest OECD biannual Economic Outlook (No. 84) records what has happened in a series of graphs of price trends for key assets:

• Residential property entered its bear market (as measured by inflation-adjusted prices) starting in the United States during the fourth quarter of 2005. This spreading bear market hit other countries, with New Zealand’s beginning in the fourth quarter of 2006.
• Fixed interest bills and bonds of non-government issuers commenced their bear market in the first quarter of 2007 before the sub-prime mortgage market scare broke out mid-year.
• Commodities toppled into a bear market from the first quarter of 2008.
• Equities weakened from the first quarter of 2008 and fell into bear markets in the second or third quarters following (Japan’s was already in a bear market from the first quarter).

All up, 2008 will be remembered as an annus horribilis for investment markets. Price trends for many different asset classes dropped together in a rare example of cross-market correlation convergence. The convergence effect on modern portfolio theory (MPT) investment portfolios over 2008 has produced an unusually high proportion of assets showing negative returns, an atypical result for diversification strategies built upon low, no, or negative investment correlations.

Correlation convergence can be expected to reverse itself as various asset classes “unbundle” at different times from the common downtrend. Unbundling will arise as governments worldwide implement low policy interest rates, financial system remedies, tax cuts, fiscal expansion and regulatory reforms to restore confidence to markets and ease recessionary conditions in 2009.

Roughly speaking, unbundling should occur as follows:

Fixed interest
Fixed interest investments should rise in value (and, conversely, fall in yield) as publicly-funded rescue plans for supporting commercial lending institutions take effect. This reversal of downtrend can in many cases occur before the real (physical, productive) economy recovers. Examples of relevant rescue plans are: