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Capital Acumen Issue 33

Understanding Correlation Drift

Investors may take certain asset relationships for granted; yet those traditional associations may be subject to change. Here’s what you should know.

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There are a few asset correlation principles most investors know by heart: Stock prices and bond yields tend to align, while stock and bond prices move in opposite directions, as do stock and oil prices. These relationships can usually be counted on. But occasionally they show no association at all. Welcome to correlation “drift.” Understanding why those drifts occur is important, especially when you’re reallocating portfolio assets. Here are some factors behind recent relationship shifts, notably the correlation between stock prices and bond yields. (See Exhibit 1.)

Historically Low Interest Rates

One reason for the drift away from traditional relationships among asset classes is years of low interest rates. “On the heels of the credit crisis of 2008, the Federal Reserve sought to stabilize the financial system,” says Christopher M. Hyzy, chief investment officer of U.S. Trust. “They did so in part by lowering the federal funds rates effectively to zero.” With the crisis essentially averted, investors assumed the rate would gradually rise to a more normal level — but that’s not what happened, Hyzy says. While the rate was 4.25% pre-crash (December 2007) and 0.0%–0.25% post-crash (December 2008), almost a decade later it is just 1.25%–1.50%.1 The Bank of England (BoE), the Bank of Japan (BoJ) and the European Central Bank (ECB) have also maintained rates at or close to record low levels. “We think central banks will remain accommodative for some time, with the United States starting to normalize first. Once rates do rise in most major economies, we expect traditional asset relationships to become more stable,” Hyzy says.

Central bank Balance Sheets

At the same time, central banks have inflated their post-crisis balance sheets. The Fed’s, for example, grew five-fold, from about $893 billion in June 2008 to $4.5 trillion in June 2017.2 Combined, the world’s four main central banks have assets totaling $14.5 trillion, “an unusually large amount that they may partly channel back into the economy, once conditions are right,” Hyzy says. (See Exhibit 2.) This action could, in turn, influence traditional investment correlations.

Changing Economic Drivers

A shift in major economies may also be weakening traditional correlations. “China recently moved from a manufacturing-based economy to a consumer- and service-led economy,” says Hyzy, “which, almost by default, has less productivity in it.” Then there’s technological innovation, “which is helping push down global costs in a range of industries,” says John C. Veit, a senior investment strategist at Merrill Lynch.† In oil and gas extraction, for example, innovative techniques such as hydraulic fracturing (“fracking”) helped drive down crude oil prices from above $130 per barrel in June 2008 to below $50 in June 2017.3 “Shifts like these may be skewing productivity data,” Veit says, “helping heighten the central bank focus on low rates.

Exhibit 1: New Divide in Equity Prices & Bond Yields

Historically these two economic indicators have showed a more or less tandem pattern of movement.

Graph representing Standard and Poor’s 500 stock index vs. U.S. Treasurys, 2017.

Source: Standard and Poor’s 500 stock index vs. U.S. Treasurys, 2017. 

Other Drivers

There are other factors that Hyzy and Veit connect to correlation uncertainty.

"Correlation drift may last longer than most people expect, and perhaps even occur more frequently."

SWFs. Many nations, especially those that produce oil and gas, “have created sovereign wealth funds (SWFs) that are at least partly responsible for recent large flows into bonds, even as other investors were seeking to benefit from a rising stock market,” says Veit. Total assets in SWFs grew from $6.2 trillion in December 2012 to $7.4 trillion in December 2016, according to the Sovereign Wealth Fund Institute.

Longevity. People are living longer — the average life span in the United States rose from 70 in 1969 to 79 in 2014, according to World Bank estimates. This may prompt retiring baby boomers to favor fixed income in a search for yield with less risk.

Millennials in the workforce. There are 75 million millennials, according to 2015 U.S. Census Bureau data, who are now a large part of the workforce, actively saving, and choosing equities over bonds as long-term investments.

Exhibit 2: Central Bank Balance Sheets

Banks across the globe have had to adapt to prolonged low interest rates in order to drive a functioning global economy.

Graph representing central bank balance sheets year wise.

Source: BofA Merrill Lynch Global Research. Data as of July 2017. Forecasts are hypothetical and subject to change.

What to do

Correlation drift “may last longer than most people expect, and perhaps even occur more frequently,” Hyzy says. In response, investors should stick to fundamentals, he adds, and focus on the profit cycle, especially in non-U.S. investments where positive growth surprises may occur more frequently. Veit suggests “more frequent portfolio rebalancing and greater diversification across asset classes, real assets and geographies.” At the same time, Hyzy recommends keeping an eye on global inflation, where a rise could indicate that central bank policies are normalizing. “At that point, traditional correlations may resume — until they drift again.”

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