Capital Market Assumptions: The Potential Impact of Financial Repression
Historical analysis and forward-looking asset return estimates argue for greater diversification away from nominal Treasuries amid financial repression.
- Financial repression refers to monetary and regulatory actions that artificially suppress interest rates; these policy moves help fulfil government objectives but can be repressive to savers due to low yields.
- Financial market reliance on policy support in conjunction with unprecedented levels of government-issued debt raises the likelihood that we will remain in a prolonged period of financial repression.
- Our analysis suggests that financial repression will increase the relative performance of stocks versus bonds, whether policy actions result in a high- or low-inflation regime.
- Periods of financial repression highlight the importance of diversification. In this environment, nominal sovereign bonds may not be as effective as non-U.S. equities and real assets in providing diversification.
During periods of financial repression, we see a change in asset correlations. In fact, all asset classes we analyzed across the 15 markets had higher correlations during periods of negative real rates (chart below). In particular, nominal bonds had the largest increases in correlations to other asset classes and the highest correlation to equities. Lower diversification properties of nominal bonds suggest it may be appropriate to increase exposure to real assets during periods of financial repression.
Financial repression has historically lessened the diversification benefits of most asset classes, especially nominal fixed income securities.
Global Return Correlations Under Different Financial Repression Scenarios
Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investment Returns Yearbook 2018, Fidelity Investments (AART), as of Dec. 31, 2018.