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Falling Correlations Spell Opportunity for Investors

Posted by hkarner - 17. Februar 2017

Date: 16-02-2017
Source: The Wall Street Journal

With stocks, bonds, and commodities no longer rising together, asset allocation suddenly matters again

Gold ccAsset classes with seemingly little in common, such as gold and technology stocks, are among the top performers in 2017 so far.

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.

Cross-asset correlation 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.

Asset classes with seemingly little in common have shone in recent weeks. Gold, emerging-markets and technology stocks rank among the top performers in 2017 so far. The prices of government bonds issued by rich countries, after rallying to record highs in some cases last year, have declined sharply in the U.S. and Europe since mid-2016, as inflation has begun to pick up.
Past indications of lower correlation haven’t turned into a more lasting breakdown. But the massive central-bank stimulus that investors say spurred the correlations is either beginning to, or is expected to, tail off, reducing their 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 multi-asset 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 and investors fanned out across markets in search of returns, pushing prices higher in equities and other investments.

During the Fed’s QE 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 over 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 AC World index.

us-returns“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-cap 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 time 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 there will be increased dispersion between German financials and French and Italian financials.

Still, with only a short period to go on, it’s too early to call the return of active managers.

“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 outflows in January, according to Morningstar. Meanwhile, lured by lower fees, many investors continue to pour money into passive funds, which notched up their 36th straight 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.


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