We’ve heard a lot about decoupling of various varieties over the past few months. One such decoupling is the resilience of equity valuations in the face of surging oil prices, says Harvard’s Mohamed El-Erian, writing in the FT’s Insight column. That offers the message that global demand can shrug off the higher cost of a raw material that features prominently in a broad range of consumer products.
That surging oil price, combined with tighter credit conditions after the subprime meltdown, would normally result in a flight to quality. But government bond yield remain well above levels registered earlier this year and in the equity markets, aggressive segments continue to outperform. In June, emerging market stock made strong gains even though the S&P spent most of its time in negative territory.
But, warns El-Erian, there are considerable lags in play – we have yet to see the full flow-through of weak residential housing market, high oil prices and individual instances of technical market dislocation. Second, he adds:
normally fundamental linkages between markets are being obscured by large flows of capital. While nobody knows for sure when these flows will diminish, it is unwise to simply assume they will last forever.
And some of the systemic forces that have boosted risky assets in recent years, ample liquidity, high growth, low inflationary pressures, are starting to wane.
Trouble is, suggests El-Erian, that the past few years, when virtually any risk asset has outperformed, has not been a good environment in which to test the appropriateness of portfolio construction, and whether by diversifying across risky asset classes, portfolios will continue to mitigate risk sufficiently.
we may well be in the middle of a regime shift: exiting a world in which the difference among individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes, and entering a world where more sophisticated risk management capabilities will increasingly be the main differentiator.