In our newsletters, blog posts, whitepapers and webinars, we write and talk a lot about the relationships and interactions between major asset classes and risk factor types. We have noted that correlations have been shifting and changing with a high frequency this year, as market participants constantly adjust their focus from trade-war fears to inflation concerns and political uncertainty in Europe. Looking back at our work over the past couple of months, we have identified the 10 most significant correlation pairs that multi-asset class investors should focus on at the moment.
1. Stocks versus bonds: economic recovery, flight-to-safety and inflation concerns
For most of the past 2 years, equity and bond prices have been negatively correlated. In the so-called ‘Trump rally’ following the presidential election in November 2016, interest rates rose together with share prices, as investors became optimistic about the US economy. This was occasionally interrupted by periods of geo-political tensions—conflicts with Russia over Syria, nuclear missile tests in North Korea, impeachment calls against President Trump, trade wars with China—during which these asset-class movements reversed, as market participants fled risky equities for the relative safety of government debt. In both these environments stock and bond prices moved in opposite directions, providing good diversification opportunities for portfolio managers.
The opposite was true, however, whenever market players were worried about inflation. In that scenario, equity and debt securities moved in the same direction—irrespective of whether the concern was about inflation being too high or too low. During most of the 2017 bull run, rising consumer prices were seen as a sign of a healthy and recovering economy, and when a monthly release came in below expectations, interest rates fell, while share prices continued to rise. This changed dramatically at the beginning of February this year, when a strong rise in average weekly earnings was considered a warning sign that the economy might be overheating. In that case, equity and bond markets both sold off, again leading to a reversal of the correlation from negative to positive. This was particularly bad for portfolio managers, as share price losses could no longer be offset by gains in fixed income investments.
2. Dollar versus interest rates and bond yields: higher rates, more attractive currency
The anticipation of more aggressive rate hikes by the Federal Reserve Bank in response to stronger consumer price growth was, however, a big plus for the US dollar, as higher interest makes a currency more attractive to foreign investors. This combination of rising yields and a stronger dollar was evident in both the equity bull market and in periods of accelerating inflation. Conversely, the dollar tended to depreciate as interest rates fell in times of heightened geopolitical risk. However, this was conditional on whether the risk related to the United States. For example, in periods of political uncertainty in Europe (French presidential election, German coalition talks, Italian fiscal policy, etc.), the relationship was reversed. In those times, the USD could be expected to gain against its European rivals, while bond yields would go down.
3. Yen versus US stock market: reliable diversification in times of crisis
In periods of geopolitical uncertainty and stock market corrections, the yen is usually one of the greatest beneficiaries, as Japanese investors are very risk averse and have a habit of repatriating their funds when things go badly in other parts of the world. Combined with its relatively high volatility, the yen’s negative correlation with the US stock market makes it an effective diversifier.
4. The pound versus everything else: decoupled due to Brexit uncertainty
The British pound, on the other hand, has been less able to profit from any dollar weakness in recent months, as its value is predominantly driven by the perceived progress of the Brexit negotiations. While a low correlation with other assets in the portfolio does usually result in an overall risk reduction, the pound’s diversification benefits are less obvious and reliable than those of its Japanese rival.
5. Euro versus stock markets: dependent on regional focus
As with the US dollar, the relationship of the euro with stock markets depended on the region traders were most focused on. For example, in the run-up of the French presidential election in the spring of 2017, equity markets and the value of the euro were both driven by who was leading in the opinion polls. Similarly, we observed a very close relationship between the two when the populist government was formed in Italy in May and around the budget announcement at the end of September. However, if the risk relates to the United States, the euro may actually benefit from a dollar weakness, while stock markets may suffer from global contagion.
6. European versus US stocks: closely related with few exceptions
Most of the time, developed equity markets have been very highly correlated across regions. Yet, we saw European and US stocks decouple briefly in late April. At the time, renewed inflation concerns led American share prices to fall, while markets on the other side of the Atlantic kept ascending.
7. Oil versus share prices: mostly positive, unless driven by OPEC action or geopolitical tensions
During the equity bull market of 2017 and all the way to the end of the first quarter of 2018, oil prices exhibited a very strong positive relationship with stock markets. Combined with the high standalone volatility of the oil price, this resulted in a very large risk contribution, compared with its market value weight from the oil holding, in our global multi-asset class portfolio. The connection broke down, however, in March, when the oil price surged after OPEC supply cuts, while stock prices were depressed by trade war concerns. The disconnect became even more apparent after the sanctions imposed on Iran by the US drove the oil price yet higher. This resulted in a negative interaction with share prices, which temporarily made the oil holding the biggest diversifier in the model portfolio.
8. Gold versus government bonds: inflation hedge versus safe haven
Another mostly positive relationship is the one between gold and government bonds. Their joint safe-haven status meant that both tended to benefit in ‘risk off’ environments, often actively reducing portfolio volatility. The only environment in which we saw the two decouple was the one of heightened inflation expectations, as bonds sold off, while gold profited from its standing as a hedge against monetary devaluation.
9. Credit spreads versus stock markets and interest rates: consistently negative
The risk premium of corporate over sovereign debt has been consistently negatively correlated with both equity markets and risk-free interest rates, as credit spreads are likely to increase when share prices fall and/or interest rates decline, each of which is usually a sign of raised risk and/or deteriorating economic conditions.
10. Italy versus other peripheral issuers: limited contagion so far, but correlations are rising
Contagion from the Italian bond sell-off to other peripheral issuers in the Eurozone seems so far to have been limited. However, correlations of yield spreads versus Bunds are approaching similar levels as at the height of the European debt crisis and there is a substantial risk that a further widening may trigger another ‘doom loop’.