boon for stock pickers (per MS)
“CORRELATIONS HAVE CRASHED: Editors at Morgan Stanley won’t let analysts use the word ‘crash’ without a good reason and its best way to describe what has happened since election across globe…regional correlations, cross-asset correlations and individual stock and FX correlations have fallen simultaneously. That’s unusual; we haven’t seen a shift this severe in over a decade. There are several reasons for this. One of them is that deep into an expansion, higher economic confidence reduces the likelihood that many markets will panic at the same time, and means market-specific stories are often bigger drivers than the more binary question of ‘recession, or not?’ Positive and negative effects of this…on the plus side, it should be a better backdrop for ‘macro’ trading. But as correlations fall, the risk that a hedge won’t work also rises. Correlation pricing has diverged most from historical norms in: AUDUSD, gold, Japan equities, EURUSD and EUR rates…so those offer some of best opportunities to position for higher volatility and higher correlations. We like USDKRW and USDJPY longs for the bear and bull case tail scenarios on still-respectable correlation with global equity risk. Small caps (Russell 2000) and to a lesser extent Nikkei and EM equities in stocks all have below-average vol and correlations today to S&P 500; makes index hedges cheaper, although the lower level of realized volatility means consensus is looking for an even better entry point to buy equity vol.”
The drivers of this matter, and we’ll touch on them briefly. But we’ll focus most of this
report on the implications, specifically:
Not a fluke: Correlation lower at all levels
The sharp drop in cross-asset correlation is not a fluke. It represents a decline in
correlations at each of the three key ‘levels’ that we care about – cross-asset, crossmarket
and intra-market. Our correlation indices (Exhibit 2) focus on the first two of
these, while the last is an important addition.
1. Lower correlation should mean a better ‘macro’ trading environment (since each
market isn’t the ‘same’ trade). It is a mixed blessing for diversification, lowering
overall portfolio volatility, but also making hedging through ‘proxies’ harder.
2. Lower cross-asset correlation is common in ‘late cycle’ environments, fitting our
preference for equities > credit. Meanwhile, USDKRW remains our favourite ‘proxy’
hedge in a lower correlation world, given its linkages to several macro risks.
3. We’d expected correlations to rise again if growth data disappointed. Since lower
correlation has helped to depress volatility, hedges that benefit from both
correlation and vol moving benefit from unusually good pricing now. Our
favourites are AUDUSD, gold and EURUSD.