There may therefore be a relationship between the decline in the correlation between equities and bonds and the low term premiums now observed in the bond market. The previous decision to change the equity share was based on the assumption of a correlation between equity and bond returns of about 0.4. Over the past decade, this correlation has averaged –0.3. In Norges Bank’s opinion, it is not unreasonable to base our advice on a lower correlation than the last time we issued advice. With a lower correlation, the fund will need a lower bond allocation than previously assumed in order to maintain return volatility at about the same level. RISK OF SUBSTANTIAL AND PERSISTENT DECLINES IN VALUE So far, my discussion of risk has focused on the fund’s expected return volatility from one year to the next. If returns are normally distributed, a standard deviation of 10 percent means, in slightly simplified terms, that the value of the fund, at its current size, will change by more than NOK 700 billion in one out of every three years and by more than NOK 1400 billion in one out of every twenty years. Even these enormous amounts may underestimate actual risk. Financial market returns do not follow a normal distribution. Major financial crises occur more frequently and with greater severity than implied by a normal distribution. An example from the recent past is 2008, when the value of the fund’s strategic benchmark index for equities fell by almost 40 percent.
When the fiscal rule was introduced, the expected return was estimated at 4 percent. The estimates presented today entail a considerably lower expected rate of return for any realistic equity allocation. As mentioned, with an equity allocation of 75 percent, the expected annual real return will be about 2.5 percent per year over the next ten years. Chart: Petroleum revenue spending over the budget Another important objective of the GPFG and the fiscal rule is to insulate the budget from sharp fluctuations in oil revenues. The GPFG is now so large and finances such a sizeable share of government spending that it may become just as important to manage swings in the fund’s value as swings in petroleum revenues. The fiscal authorities face an important trade-off: on the one hand, closely linking fiscal policy to changes in the value of the GPFG will have a substantial impact on other government spending and revenues from one year to another. This is far from desirable. On the other hand, a substantial degree of decoupling between changes in the GPFG’s value and government spending of its funds over the budget could lead to greater uncertainty about the value of the GPFG in the longer term. Oil revenue spending should be based on a realistic estimate of expected return. At the same time, due consideration must be given to return uncertainty. It may therefore be wise to consider spending somewhat less than the expected return over time.