The wild ride in the equity market continues, as stocks have recovered from losses a mere few weeks ago. There's an important takeaway from this roller coaster ride-- diversification works.
We look at the market as having two broad asset classes-- risk assets, those asset classes that look and act like global equity, and risk control assets, safe assets like cash and high quality fixed income. Risk assets include not only US and non-US equity, but also include high yield bonds, public real estate, and infrastructure.
When we think about diversification, we think about asset classes that have a low correlation, that act differently from each other. We rely on diversification during periods of market stress. It's our primary risk management tool. While we know the correlations in the risk asset bucket rise during market stress, and we observed this in the fourth quarter when all of these asset classes fell in tandem, we depend on the low correlation between risk and risk control assets.
Despite the sharp and fast global market sell-off, we saw the benefit of this diversification as risk control assets actually had a negative correlation to risk assets. That's the very definition of durable and reliable diversification.
Looking forward into 2019, we're constructive on risk assets. We believe that the global economy will avoid a recession, that inflation will remain low, and that global central banks will remain easy. We think that the Federal Reserve may raise rates one more time this year, or maybe not at all, as investors increasingly are betting that the Fed may stand pat.
That said, it's likely that the global markets will remain volatile as investors adapt to a lower growth environment, and continue to grapple with a myriad of risks, including the resolution of the US-China trade talks, Brexit, the debt ceiling, and concerns about a Fed mistake.
Preparation begins and ends with a careful sizing of your risk control portfolio. For investors, now's the time to make sure that your buffer, your risk control portfolio, is sized appropriately. Risk control provides portfolio stability, and also provides liquidity that you may need to fund goals or meet near-term cash flow requirements.
Don't be forced to sell risk assets into a downturn. So risk control assets can provide an important source of funds. For investors, it's far better to be prepared than to try to predict short-term risk asset price movements.