Notwithstanding the jitters seen at the prospect of higher US interest rates, the high positive correlations seen in market movements across asset classes, different regions and across sectors in the last few years may be coming to an end.
The quarterly review of Bank for International Settlements (BIS) for March says that after the global financial crises, markets and assets moved in tandem, affected by waves of “risk on” and “risk off” sentiment. The review says, “In a global environment devoid of growth but plentiful in liquidity, central bank decisions appeared to draw investors into common, successive phases of buying or selling risk.”
That, says the BIS, is no longer the case. In an environment of high policy uncertainty and differentiated growth, the co-movement of various assets has been reduced.
By way of example, the review states, “In the United States, there were clear winners (defence, construction, financials, manufacturing, small firms) and losers (import-intensive sectors) even as the overall indices reached new highs.”
The accompanying chart shows the fall in average correlation coefficients. A correlation coefficient of +1 indicates perfect positive correlation, while -1 indicates perfect negative correlation.
Claudio Borio, head of Monetary and Economic Department at Bank for International Settlements, said, “The breakdown in correlations stands in stark contrast to most of the post-crisis experience, when successive waves of risk-on/risk-off behaviour tended to raise and lower all boats.”
In other words, global policy uncertainty is likely from now on to weigh differently on different regions and different assets. That differentiation will certainly not mean a decoupling, but it does raise the hope that countries that are growing more strongly, or are doing more by way of reform, could see stronger inflows to their markets. Also, countries less exposed to the risks emanating from possible US protectionism, which are seeing an appreciation of their currencies, might benefit more as dollar investors get higher returns.
The Indian market seems to have benefited from this greater differentiation. Year to 7 March, the MSCI India equity index, in greenback, has gained 11%, well above the MSCI EM return of 8.6%, or the MSCI EM Asia return of 9.5%. And this has happened despite relatively high valuations.
Correlations always go up during periods of both extreme fear and extreme optimism. The assumption seems to be that global markets are now moving back to a more normal pattern after the financial crisis.