Curious correlations: The importance of relationships
As the Queen told Alice ‘Sometimes I’ve believed as many as six impossible things before breakfast’.
We live in a curious world, one where curious correlations periodically affect markets, but also where changes in those curious correlations can also inform or confuse some investors.
A very important relationship so far this year has been between the oil price and the US dollar. Only a few weeks ago, upwards pressures on the dollar helped pull oil prices below $30 per barrel, in turn putting extreme pressure on emerging market assets. In recent days, however, while the US dollar has begun to strengthen following more hawkish Fed commentary, the relationship with oil prices has been rather looser – indeed oil has threatened to rise above $50. Digging deeper, we can find an explanation: while changes in the dollar clearly have an effect on commodities priced in that currency, other factors matter over time. In May, oil supply was severely affected by disruption in Canada, Nigeria and Venezuela, bringing about a much closer balance with demand than expected even a short while ago. Oil matters because of the interesting relationship with the direction of emerging market equities, developed market inflation expectations and even inflation linked securities.
Some correlations do appear to work over short periods of time, but break down over longer time spans. For example there is some relationship between economic growth and stock market performance –at the end of the day changes in GDP do drive corporate sales. However, over longer periods of time the relationship can be rather loose, even turn negative! Again some detailed analysis can help explain why. In many cases, the stock market is not that related to the domestic economy, but to the global economy, as in the case of the UK, or to a select number of industries, as occurs in many emerging markets. The type of growth will also matter: if increases in capital and labour inputs go to new unquoted companies, then this would not increase the present value of dividends from existing firms.
A third issue to examine is the connection between different correlations. There are loose relationships, of course, between many financial assets, say driven by growth prospects or a common global discount rate. However, on occasion those correlations can become much closer – a clear example occurred last spring when financial stress built up. At such times constructing truly diversified portfolios becomes even more complex. Internal tools, such as our Financial Stress Index, are just one way of understanding how these relationships form, break up and re-form.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Citywire Wealth Manager 9th June 2016.