Factor correlations change as spotlight shifts to Europe
During the first half of this year, we saw a notable shift in major risk factor correlations, in particular between equity and foreign exchange returns. This significantly impacted the volatility of Axioma’s global multi-asset class model portfolio, both in terms of asset class contributions, as well as diversification from underlying factor drivers.
In the aftermath of the US presidential election in November last year, we had observed a strong positive correlation between global stock markets, government bond yields, the US dollar exchange rate versus other currencies and the oil price. By the end of the year, both the US stock market and the dollar had gone up by 5%, while the 10-year US Treasury yield had surged upwards by more than 70 basis points and oil prices had risen by over 20%. Good news for the economy (not just in the US) meant good news for the US dollar, too.
The fact that gains in non-USD assets were offset by strong exchange rate movements made it appear as if those assets were losing money from a US investor’s point of view, while the domestic stock market was breaking through one record high after another. Although this made foreign securities look undesirable from a returns perspective, it was excellent news for portfolio diversification. The apparently inverse relationship between US and non-US assets made the latter seem like a good hedge for the former, and risk contributions from all equity holdings appeared to be a lot lower than one would expect.
Also, fixed income securities seemed to offer a lot less diversification than usual. Their negative interaction with stock markets meant that their returns were positively related to FX gains and losses, which meant that the returns of non-US bonds were amplified by exchange rate changes. This, in turn, resulted in a higher risk contribution from fixed income securities in general, due to the strong relationships of government bond markets globally.
When the market focus shifted from the US economy to political risk in Europe at the end of the first quarter, correlations between stock markets and exchange rates also started to change. As the French presidential election drew closer, an increase in risk appetite was suddenly accompanied by an appreciation of European currencies against the USD. The resulting stronger positive interaction between global stock markets produced a higher risk contribution from all share holdings in the portfolio (90% instead of half of the risk in the previous example). On the flipside, the reduced impact of the exchange rate also meant that more “traditional” diversifiers, such as government bonds, gold and the Japanese yen, could come to the fore.
With the ongoing dollar weakness and stock markets continuing to post record highs, the correlation between equity and FX returns remains firmly positive. And given the uncertainty surrounding the stability of the British government as Brexit negotiations plough ahead, the arguments between hawks and doves at the BoE over whether to raise rates or not, the upcoming parliamentary elections in Germany, and the simmering banking crisis in Italy, we can expect the spotlight to frequently turn on Europe over the coming months.
For a more detailed analysis of this, please refer to our latest research paper Factor Correlations Revisited.