Falling Correlations Spell Opportunity for Investors
Wall Street Journal / Christopher Whittall
The tight synchronization that has characterized financial markets for much of the past decade is breaking down, presenting investors with opportunities and risks they haven’t grappled with in years.
Global stocks, bonds, currencies and commodities have parted ways in recent months, after largely rising in lockstep for most of the post-financial-crisis period.
Correlation among assets recently fell to its lowest level since 2006, according to a Morgan Stanley analysis of 34 indicators tracking the relative performance of different asset classes and regions.
Developed-world stocks and bond prices climbed in the summer of 2016 on a belief weak growth would persuade central banks to keep their massive stimulus programs in place for longer. But as expectations cranked up for higher growth and less stimulus, differentiation made a comeback. Bond prices crumbled and stocks surged.
Markets that once moved closer together were parting ways. U.S., small-cap stocks outperformed large caps. Commodities remained resilient despite a rising dollar, which makes these assets more costly. Emerging-markets investments took a dive as investors anticipated greater protectionism following the election of U.S. President Donald Trump.
Past indications of lower correlation haven’t turned into a more lasting breakdown. But the vast central-bank stimulus that investors say spurred the correlations is either beginning to tail off, or is expected to, reducing its sway on markets, some investors say. That could create a rare opening for active-fund managers, many of whom suffered significant outflows in recent years as money migrated toward simple, low-cost, index-tracking funds.
“When central banks were easing, you could pick any [asset class] and you’d look a hero. Now asset allocation does matter,” said Paul O’Connor, head of multiasset investments at Henderson Global Investors.
Correlations typically spike during periods of turbulence, as investors shed anything they consider risky and head into safer markets en masse. The synchronicity declines as nerves calm and investors take diverging views on prospects. That happened during the global financial crisis of 2008 and Europe’s sovereign-debt crisis from 2010 to 2012.
Central banks’ response to those troubles ensured the correlation continued. By lowering interest rates toward and below zero, and buying trillions of dollars of bonds, central-bank action pushed government-bond yields lower across the board. Investors fanned out across markets in search of returns, pushing prices higher in equities and other investments.
During the Federal Reserve’s quantitative-easing programs, which started in November 2008 and ended in October 2014, global, U.S. and emerging-market stocks all earned investors returns of 15% or more a year, as did high-yield bonds. Oil, nonprecious metals, emerging-market debt and high-grade corporate debt all gained more than 8% annually.
Since October 2014, performance has been more mixed. Investors in emerging markets and commodities have generally lost money. Yearly returns for equities on average have been positive, but lower, at 10% for the S&P 500 and 5.6% for the MSCI All Country World Index.
“This is the end of QE lifting all boats,” said Jean Médecin, a member of the investment committee at Carmignac.
Active managers’ sales pitch to clients is simple: Making money requires greater skill when assets prices can go down as well as up.
There is some early evidence that active managers are starting to outperform. Over half of large-capitalization U.S. fund managers beat their benchmark in January, potentially signaling a better environment for these investors after nearly a decade of underperformance, according to a recent report from Bank of America Merrill Lynch.
Active managers of so-called world-allocation funds—which invest in a mixture of stocks, bonds and cash—on average returned 1.6% from September to the end of January, according to Morningstar. That compares with an average of 0.06% for similar passive funds over that period. That reverses a trend of passive funds outperforming in the first eight months of last year.
There also has been differentiation within bonds and equities between individual firms, said Michael Hintze, founder of hedge fund CQS, which runs around $12 billion in assets.
Given heightened political risk in Europe with elections in France and potentially Italy, Mr. Hintze sees opportunities in the region’s financial sector, where he says there will be more variation between the performance of German companies and their French and Italian counterparts.
Still, with only a short period to go on, it is too early to say active managers are set to make a comeback.
“In theory, there is a better backdrop now, but obviously those fund managers would still need to pick the right things,” said Andrew Sheets, chief cross-asset strategist at Morgan Stanley.
Despite the steep decline in correlations, U.S. actively managed funds still recorded their 21st consecutive month of net outflows in January, according to Morningstar. Meanwhile, lured by lower fees, many investors continue to pour money into passive funds, which notched their 36th consecutive month of inflows.
Cosimo Marasciulo, head of European fixed income at Pioneer Investments, believes that less correlation is good news for active managers such as himself. Among other things, he is betting on rising inflation hurting global bonds, as well as that jitters in European debt markets over political risk are overdone.
But Mr. Marasciulo is wary that markets can soon turn, particularly if there is a bout of turbulence.
“You have to be cautious, because correlations are unstable,” he said.