Will Greater Asset Class Correlations Endure?

By James Picerno, Director of Analytics

Correlations between the major asset classes spiked earlier this year following the market meltdown. Although the surge has faded a bit in recent months, it remains sticky at a relatively high level.

Consider the median of the rolling one-year correlation for the major asset classes (based on daily returns) via a set of proxy ETFs. Surging to 0.55 earlier in 2020, the median’s retreat has been modest and so correlations remain elevated. (Note: correlation readings range from -1.0 (perfect negative correlation) to zero (no correlation) to +1.0 (perfect positive correlation.))

Will the jump in correlations endure after the pandemic finally comes to an end? This is more than an academic question since higher correlations imply lower benefits from asset-class diversification, which would increase the need for alternative risk-management techniques to pick up the slack.

The answer, of course, is unknown for the usual reason: the future is as uncertain as ever. But it’s reasonable to wonder if the standard ebb and flow of correlations that usually prevails have given way to relatively high return similarities that will continue for longer intervals than has previously been the case, or perhaps even permanently.

The raw material that arguably has contributed to what may be a regime shift for correlations includes the arrival of extraordinarily dovish monetary and fiscal stimulus programs the world over. As The Economist this week observes, “The pandemic has accelerated a rethink of macroeconomics. It is not yet clear where it will lead.”

This change has been brewing for a decade, ever since central banks and governments responded to the 2008-2009 financial crisis. The stimulus never really went away, although it did fade in varying degrees around the world. But when the coronavirus shuttered much of the global economy earlier this year, the focus shifted back to dovish policies and in a degree that’s unprecedented. Given how deep the world has gone down the monetary and fiscal rabbit hole in 2020, it’s unclear how soon, if ever, the global economy will return to “normal.”

(An earlier version of this article was originally posted on The Capital Spectator on July 29, 2020.)

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