Recent years have been marked by a remarkably high degree of positive correlation among financial assets that is well above historic norms, and that suggests trouble ahead, according to analysis by Deutsche Bank cited by The Wall Street Journal. When different asset classes move in the same direction simultaneously, that limits, if not eliminates, the possible benefits of diversification across classes as a risk management tool.
Moreover, when such high correlation reigns, a negative development sending one class tumbling may create a widespread avalanche. A possible catalyst for that avalanche right now is President Trump's renewed threats to hike tariffs on Chinese goods.
Among 70 financial asset classes tracked by Deutsche Bank, through April 2019 almost 90% have posted year-to-date positive total returns (price appreciation plus income, such as interest or dividends) in U.S. dollar terms. These classes include a variety of stock market and bond market indexes from around the globe, in addition to oil and other physical commodities, as well as cryptocurrencies, among others. The table below lists just a few factors that could shift the 2019 "Everything Rally," as the Journal dubs it, sharply into reverse.
Why The 'Everything Rally' Could Reverse Soon
- Protracted U.S.-China trade war.
- Global economic growth deceleration.
- Increasingly interconnected global markets.
- Diminished liquidity.
- Rising volatility.
Significance for Investors
“It’s been like a bungee jump on a slingshot,” as Peter Atwater, a research analyst and an adjunct lecturer at The College of William & Mary, described the situation to the Journal. He is “very troubled by the correlation” as well as by declining volatility.
Additionally, shrinking market liquidity may increase the magnitude of future selloffs, and reduced liquidity is partly the result of regulatory initiatives such as the Volcker Rule that sought to make the banking system safer by limiting the ability of banks to make markets in securities. “That shock absorber isn’t there anymore,” as Matt Pecot, the head of Asia Pacific equities at Barclays, told the Journal. “And it’s making the system as a whole more volatile,” he added.
Seeking diversification by investing across borders also is running into limits lately. "The markets are more closely tied together than they've ever been before," observes Michael Parker, Hong Kong-based head of research and strategy for the Asia Pacific region at Bernstein, in remarks to the Journal. "In a globalized world with a free flow of goods, services, people, ideas, and capital, you'd think there should be a greater degree of correlation with all of this stuff," he added.
In 2018, a record 87% of the 70 asset classes tracked by Deutsche Bank fell in value. In 2017, an astonishing 99% rose in value, for the broadest rally ever. Based on history since 1901, a typical year sees about 70% moving in the same direction. Deutsche Bank finds that six of the broadest rallies in history, in terms of the number of asset classes heading upwards, have occurred since 2000.
On Monday, May 6, the S&P 500 Index (SPX) was down by 1.2% at the open and eventually dipped as low as 1.6% beneath the previous close on Friday, May 3, before staging a modest rally and ending the day down by just 0.5%.
Even if trade tensions ease between the U.S. and China, other potential negatives loom for the markets, such as the others listed above. Another is the possibility of renewed bout of inflation that spurs a policy reversal by the Federal Reserve, sending interest rates upward once again.