fa01 Mike Dolan correlations between the main asset classes as

 

By Mike Dolan

LONDON | Wed Mar 9, 2011 2:01am EST

LONDON (Reuters) - Even as a truly unpredictable political event unfolds across the Arab world this year, global investors appear more comfortable than they have been for years in coping with the financial fallout.

That's not to say the viral unrest that has spread across the Middle East and North Africa since January is positive for world asset prices -- a sustained oil price spike clearly has the opposite effect on stocks and bonds alike.

But, unlike the existential threat to the entire financial system presented by the credit implosion of 2007 and 2008, investors can more easily price and discount the main economic fallout from the current unrest -- namely higher energy costs.

Take correlations between the main asset classes as a key indicator of market stress -- where lockstep movements between prices, so often indicative of violent herding, are denoted by a maximum coefficient of 1 and where zero shows no link at all.

One of the most striking features of the credit bubble -- both in its final throes and especially after it burst -- was a surge in correlations between major assets. Indiscriminate demand for risk and yield gave way to the polar opposite and this behavior persisted as the risk-on/risk-off metronome ticked back and forth over subsequent years.

The inability to quantify the systemic risks to the financial world saw investors stampede into cash; cash-like securities like top-rated, liquid U.S. Treasuries; and gold.

Everything else -- equities, corporate debt, most commodities, emerging markets, real estate, private equity, hedge funds -- suffered in tandem and correlations between these assets soared to near lock-step 1.0.

With U.S. cash and government securities one of the few beneficiaries, the dollar saw extreme negative correlations with most assets as it moved in the opposite direction.

NEAR-ZERO CORRELATIONS

So, it's curious then that in the midst of one of the most surprising and dramatic global political upheavals for years, financial markets appear to be unwinding those high-stress correlations and resuming more "normal" and diverse behavior.

The most dramatic illustration has been the steep drop over the past three months in a rolling 25-day correlation between percentage moves in oil and world stocks .MIWD00000PUS from as high as 0.75 to a barely significant -0.18 this week.

A simple explanation may be that oil's recent spike is no longer just part of a parallel commodities/equity reflation and growth trade but has now reached levels which crimp global demand and hence the equity of firms dependent on that.

But the drop in correlations is not confined to crude. The equivalent correlation between world stocks and the U.S. dollar .DXY, for example, has also dropped since December from a hugely negative -0.75 to less than -0.18.

Emerging market equity .MSCIEF correlations with oil and the dollar tell a similar story and even the link between emerging stocks and Wall Street is now below 0.5. Emerging market debt correlations with Wall Street stocks are close to zero.

If the ebbing of correlations is sustained, one conclusion is that a more "normal" investment environment may be returning -- one in which idiosyncratic differences between markets and assets return to importance and investors can diversify and spread their savings more broadly and with confidence again.

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• The very damage inflicted by high crisis correlations on diversified funds -- such as classic models used by Harvard and Yale endowment funds -- has also accelerated the fund industry's move to more nimble and sophisticated strategies and away from index and benchmark targeting.

  Central to the shift is the growth of so-called Absolute Return funds, which effectively act like hedge funds with more limited risk taking but with similar ability to go long or short on securities and derivatives.

  The extent of this shift, and the expected returns driving it, were captured in a survey last year commissioned by asset manager Pioneer Investments of almost 500 European institutional investors with assets of some 2.65 trillion euros.

  More than 60 percent of investor groupings within the survey -- banks, insurance companies and pension funds -- said they were now opting for absolute returns strategies.

  With an ambitious mean annual return target of some 4.4 percent -- significantly higher than money market cash rates or top-rated bond yields -- and after one of the worst decades in 60 years for a mixed investment fund, the need to break from the herd has never been clearer.

  And the shift is global. Thomson Reuters' Lipper estimated absolute-return mutual funds were in excess of $140 billion in the final quarter of last year and U.S. asset managers Putnam reckon that could grow to as much as $1.5 trillion -- or 15 percent of the industry.