Changing correlations: Capitalising on opportunities in challenging markets

Market Views And Insights | November 27, 2017

Portfolio Solutions Group (PSG)

Executive Summary

Changing market correlations is a complex and import term, influencing how assets are ultimately allocated.

This white paper examines this important topic from three angles:

  • Section 1: Macro factors shaping market correlations:
  • Myriad macro factors, both secular and cyclical, have contributed to a change in cross-asset correlations including: integration of global markets, synchronised macroeconomic (monetary) policy, financial innovation, and evolving trading strategies.

  • Section 2: Impact on asset classes (equities and bonds):
  • Equities and bonds typically form the foundation of investment portfolios due to their availability and historica negative correlation relationship. But as markets have evolved so has their relationship. Our proprietary analysis examines data over the past two decades, then identifies key macroeconomic and market factors that help investors assess how and when correlations for this key asset pairing may change in the future.

  • Section 3: How investors and investment managers should respond:
  • Investors have myriad ways to respond to these changes.

    • Asset allocation approach
    • Investors and investment managers can respond by adopting different asset allocation approaches. Both the traditional and flexible approaches boast unique strengths in navigating the market environment.

    • Investment ideas
    • Adopting new investment ideas is another way to respond. Viewing asset classes at a more granular level is one idea: increased dispersion among sectors and geographical markets translates into potential opportunities. Implementation of trades also rises in importance as efficiency becomes more critical in competitive markets.

      Changing correlations introduces a raft of new challenges. However, by understanding the causes and potential ways to respond, investors and investment managers can capitalise on opportunities in volatile markets.

I. Changing market correlations

Changing market correlations is not a new phenomenon. Indeed, correlations among asset classes have never been fixed; however, the pace of change has arguably intensified over time for various reasons.

Market integration is one key factor. Beginning in the 1980s, and quickening in the 1990s, asset class correlations gradually strengthened as free trade agreements proliferated and inter-regional capital flows increased1. Previously inaccessible markets were opened to investment; investors were also able to invest and repatriate capital in emerging markets with new financial instruments and fewer limitations.

Financial crises have also changed market dynamics. Amid the inexorable integration of financial markets, the Global Financial Crisis (GFC) of 2007-2008 served as a key inflection point. As the US subprime mortgage crisis was transmitted globally, financial contagion devastated markets from Stockholm to Seoul; elevated correlations across asset classes meant investors had few places to hide. This was not a short-term event. As Figure 1 shows, correlations between US equities (S&P 500) and other asset classes stayed elevated in the post-crisis era: from a pre-crisis (1988-2007) cross asset median correlation of 0.44 to a post-crisis (2010-2015) median of 0.702.

Figure 1: Asset movements, pre-and post-crisis3

Source: IMF Global Financial Stability Report, April 2015.

The GFC and its aftermath also revealed that other factors may also be contributing to changing market correlations.

We believe there are at least three factors, both cyclical and structural, that have contributed to this change.

  • Synchronised macroeconomic (monetary) policy: Although more cyclical in nature, macroeconomic policy has likely been a factor behind shifting correlations. After the GFC, global central banks adopted unconventional monetary policies to pump liquidity into the financial system: from slashing interest rates to zero to the massive government purchase of bonds. Evidence suggests these monetary policies have eased broad financial conditions4, and contributed to alternative bouts of "risk-on/ risk-off" investor sentiment5 that resulted in elevated correlations.
  • Financial innovation: Innovative financial products may also have contributed to changing correlations. Derivatives and indexed products have broadened investor access to a range of asset classes. For example, commodity investors previously needed substantial capital and market knowledge to enter the market. Investors using new products, both institutional and retail, possess different credentials and investment goals. As a result, correlations between oil and non-oil commodities (indexed products), as well as commodities and equities, have increased6.
  • Market trading strategies: Trading strategies have changed over time. New strategies such as high-frequency trading have gained prominence due to the speed of profits and how trades can be automated. The strategy has become a key force in both options and equity markets. Evidence suggests that this may lead to increased crossasset correlations over time as well7.

The shifts in market correlations over time pose myriad new challe These challenges are particularly acute at the asset class level where are often made with reference to historical correlation relationships.

The relationship between equities and bonds has traditionally played an important role in portfolio allocation. Indeed, the asset pair’s historical negative, stable correlation made it useful for investors to diversify holdings.

Figure 2: Global equity-bond correlations, 1989-20168

Source: Manulife Asset Management analysis; Bloomberg.

However, the relationship appears to be changing over time. As Figure 2 shows, global equity-bond correlation displays notable volatility over the past roughly three decades, including extended bouts of positive correlation. This volatility is not only observed during stressed periods such as the two financial crises - the Asian Financial Crisis (1997-1998) and the European Sovereign Debt Crisis (2010-2012) - but also under a relatively steady environment.

II. Framework for analysing equity-bond correlations

To assess how this changing relationship may impact investors, we conducted a timeseries analysis using monthly equity total return (MSCI ACWI Index) and bond total return (Barclays Global Treasury Index) spanning almost the last two decades9.

We analysed how four important macro-market factors are related to the changes in equity-bond correlations over this time period. These factors were selected from a proprietary research process; they have also been found as useful indicators for asset class correlations.

The four macro-market factors are:

Macro factors

  • Global activity growth: a measurement of global economic activity provided by Goldman Sachs;
  • Global inflation: a measurement of inflation using consumer price index (CPI) data from major global economies.

Market factors

  • Market volatility: a measurement of market volatility provided by the Chicago Board Options Exchange's (CBOE) VIX Index of S&P 500 options;
  • Financial conditions: a measurement of monetary and financial conditions using the Citi Financial Conditions Index.

Based on the overall direction of correlation, positive (negative) returns of the asset class, and impact of the macro-market factors, the results of the analysis can be categorised into four scenarios (Figure 3).

Figure 3: The four scenarios of equity-bond correlations

Source: Manulife Asset Management analysis; Bloomberg; National Bureau of Statistics; Goldman Sachs Global Investment Research.

Scenarios one and two: Positive correlation between equity and bond returns

Scenario one shows stable macroeconomic and market factors.

Accelerating global activity growth drives positive returns for equities, while stable or lower inflation supports returns for bonds. Low market volatility and increasingly accommodative monetary conditions are constructive for the positive return environment of both asset classes.

Scenario two also exhibits a positive correlation; however, it is a function of negative equity and bond returns.

The macro-market factors are less favourable: Global economic activity is decelerating (negative for equity) amid rising global inflation (negative for bonds). Less favourable macroeconomic conditions are accompanied with higher levels of market volatility and, most importantly, tighter financial conditions. This results in negative returns for bonds and equities.

Scenarios three and four: Negative correlation between equity and bond returns

Scenario three is positive for equity returns supported by accelerating global activity growth. However, the scenario is negative for bond returns as the impact from moderately rising inflation outstrips the effect of lower volatility and accommodative monetary conditions.

Finally, scenario four may be considered the "outlier" among the four scenarios.

The scenario's outcome of negative equity returns and positive bond returns do not intuitively align with the macro-market factors, as accelerating global activity growth and rising global inflation would normally support equity returns but are negative for bonds. One reason for this dissonance may be due to investors' "flight to safety" amid rising market volatility, thus intuitions about how asset class relationships would work in general do not hold.


This framework can provide us with a better understanding of the equity-bond relationship under different market scenarios. By analysing the selected macro-market factors being closely monitored by our in-house experts, we are in a better position to identify changes in equity-bond correlations.

The results from analysing these macro-market factors were generally consistent with traditional assumptions about asset class performance, such as accelerating global activity growth supporting equity returns. However, as shown, sometimes these relationships do not hold. Accelerating global activity growth led to positive equity returns in scenarios one and three, but not in four. The difference is due to the relative strength of other macromarket factors (market volatility) which dominated as a driver of equity and bond returns.

Specific macro-market factors may be useful in understanding the future trajectory of equity-bond correlations. For example, weak global activity growth, or a reasonably large systematic event, usually coincides with declining or bottoming equity/bond correlations in negative territory. Another key relationship was that correlations become highly positive in the latter stages of an economic recession. These findings can be potentially used by investment managers when making asset allocation decisions.

Overall, our proprietary research shows that correlations between equity and bonds are influenced by macro factors that can help inform when correlation/asset allocations may change. The next section will examine how investors and investment managers should react to changing markets and asset class correlations.

III. How to respond as an investor and investment manager

Our paper has thus far focused on examining the impact of changing correlations on markets. The first section looked at potential macro reasons why market correlations have shifted over time, while the second section assessed how and why the relationship between two asset classes (equities and bonds) changed.

This section offers actionable recommendations for how to navigate these changes. Different asset allocation approaches offer unique opportunities to succeed in the current market environment. Looking at new investment perspectives may also be useful. Viewing asset classes at a more granular level and prioritising efficient market execution are two potential ways to respond to changing correlations.

A. Adopt a more flexible approach in asset allocation

Correlations play an important role in asset allocation. This section looks at how both conventional and the flexible approaches can confront the changing investment landscape. Each approach offers unique strengths and limitations, with some investors preferring the flexible approach due to its nimbleness in increasingly volatile markets.

1. Conventional Asset Allocation Approach

Modern Portfolio Theory (MPT), put forth by Harry Markowitz, is one approach that has been popularised by academia and investment advisors over the past few decades. In 1952, Markowitz showed that investors should not evaluate assets individually based on their risk and return profile; rather, they should be analysed on their contribution to the portfolio's other holdings, including overall risk and return profile10.

MPT suggested investors should pursue an investment strategy that selects assets for portfolio inclusion that have less than perfect correlation. By doing so, overall portfolio risk would be lowered, while expected returns would be unaffected. This selection process ultimately gives rise to a group of optimally constructed portfolios on the "efficient frontier"11.

To put Markowitz's theory into practice, investor portfolios were constructed with multiple asset classes that had less than perfect correlation. Based on an investor's risk or return expectation, strategic asset allocation guidelines were created, using the efficient frontier as the long-term asset allocation policy. Conventional portfolios with a "60-40" allocation (60% equities; 40% bonds) were commonly selected as they offer a moderate risk/return profile that suits a wide group of investors.

As the approach grew in popularity, variations of this strategy, such as the "50-50" (50% equities; 50% bonds), and "70-30" (70% equities; 30% bonds) emerged to meet the needs of different investor groups. These options provided a spectrum of appropriate asset allocation guidelines that adjusted for different investment goals and risk tolerance, with less risk-adverse investors choosing greater equity exposure.

Asset allocation decisions in this conventional approach typically rely on historical correlation relationships between major asset classes such as equities and bonds. Equities and bonds were selected as they composed the bulk of market assets accessible to most investors at the time. They also demonstrated complementary properties.

Figure 4 shows the correlation relationship between equities and bonds in the US. Traditionally, equities have performed well during times of economic growth, while bonds have provided support during times of economic hardship. As a result, portfolios that hold both equities and bonds provided a smoother ride across different market cycles.

Figure 4: Correlation between US equities and bonds, 1982-2016

Source: Manulife Asset Management analysis.

However, changing market dynamics challenge the basic tenet of the conventional approach: The correlation between equities and bonds has become less reliable. As noted in the previous section, the equity-bond correlation between equities and bonds can change due to various specific macro-market factors. The strategic (top-down) nature of the conventional asset allocation approach limits investment managers' ability to effectively adjust their strategic asset allocation policy.

The conventional asset allocation approach has an impressive historical pedigree and industry reception, even though its theoretical underpinnings may be shifting. That said, the equity-bond correlation may continue diverging from historical norms. In this evolving market environment, investors may consider an alternative strategy using a flexible asset allocation method.

2. Flexible Asset Allocation Approach

As correlations in financial markets deviated from historical norms, along with and highvolatility events such as the GFC, investors changed their perspective on risk: Risk was increasingly viewed as protection against investment loss rather than simply volatility. In response, some investors wanted a more nimble, dynamic approach to markets.

The flexible asset allocation approach allows for greater latitude in portfolio management. In contrast to the conventional approach, a flexible approach allows investment managers to manage portfolios with a much wider asset allocation range. The difference is palpable: The flexible approach allows asset exposure to vary through the market cycle.

Investment managers synthesise numerous information sources to make allocation decisions, including macro-market factors and correlation considerations. After evaluating these factors, investment managers can allocate based on their conviction levels accordingly, subject to specific investor preferences and constraints. Subject to specific investors' preference and constraints, investment managers could allocate based on their conviction levels by evaluating these factors. Exposure to assets that are not expected to offer attractive value to the portfolio whether through returns on an absolute return basis or through offering the benefit of lowering risks- would be minimized.

This asset allocation approach offers flexibility desired by many investors, especially in volatile market conditions. During these times, the strategy presents opportunities for investment managers to focus allocations in high conviction opportunities. For example, in some portfolios, cash holdings can range from 0%-30%, which positions investment managers to potentially minimise loss or generate positive returns when many asset classes are registering losses.

With greater flexibility in asset allocation, a holistic risk management framework is needed to protect portfolio value. Absolute levels of volatility of the underlying asset classes and their contribution to overall portfolio volatility need to be closely monitored. More importantly, the value-at-risk of the portfolio can shift very quickly as correlations change. As a result, changes in correlation also need to be closely monitored.

The flexible asset allocation approach provides the benefits of a wider asset allocation range, allowing investment managers to dynamically adjust the asset exposure through the fast-changing market conditions using the analytical framework of the macro-market factors. When complemented with a rigorous risk management framework, this asset allocation approach offers an alternative for investors to navigate through different market cycles.

Adopting a more flexible asset allocation approach is just one way investors can respond to the new investing landscape. Viewing asset classes at a more granular level is another.

B. Viewing asset classes at a more granular level

The ability to dive deeper into asset classes becomes more important in the current market environment. Indeed, the ability to view asset classes at a more granular level provides attractive opportunities for investors (Figure 5).

In conventional portfolio construction, strategic guidelines suggest the percentage of total assets allocated to equity and fixed income. Once the initial asset allocation is made, the investment manager further distributes to sub-asset classes such as regional markets (equity) and various fixed income sectors. This top-down approach, however, is not conducive to seeing where potential opportunities exist below these levels. If returns within certain sub-asset classes outperform the overall asset class average, opportunities may be lost.

Figure 5: Viewing asset classes at a granular level

Source: Manulife Asset Management analysis.

Initial evidence suggests that adopting a granular perspective is becoming more important. The increasing dispersion in returns within conventional asset classes suggests that opportunities can be found beyond the broad level. As Figure 6 shows, the difference between the best and worst performing sectors in global equities and bonds has widened from a recent nadir. For global bonds, the return difference could at times be as high as 15%-20%.

Looking at equities, for the first half of 2017, the best performing equity sector - technology - returned close to 18%. The worst performing sector - energy - registered a loss of 9%, presenting investment managers with potential source of value-add.

Figure 6: Increasing dispersion in equities and bonds, 2002-2016

Source: Manulife Asset Management analysis.

Granular opportunities are not limited to sectors. Dispersion amongst countries is also forecast to be substantial. For example, according to Manulife Asset Management's proprietary five-year forecast of returns for different markets (Figure 7),: the Emerging Market regional average is expected to return 8.2% - but Indian equities are slated to return 11.7%, and Brazil 5.7%.

Granularity offers a greater range of investing options; however, those opportunities can only be grasped through disciplined action, such as efficient trade implementation. The last section will explore how implementation is rising in importance along with correlations, as fund managers who trade the most efficiently in an increasingly competitive market may have a greater opportunity to achieve higher returns.

Figure 7: Dispersion among emerging markets, 2017-2022 (forecast)

Source: Portfolio Solution Group, March 31, 2017.

C. Efficiency in implementation is another key consideration

With the fast-changing nature of the market, unnecessary slippage in execution must be reduced and risks managed to ensure that small gaps in implementation do not arise.

To construct a portfolio efficiently requires a combination of different vehicles, depending on their effectiveness in expressing the investment manager's view. They can range from physical securities (e.g. bonds and equities) to managed vehicles (e.g. actively managed mutual funds or passive exchange-traded funds/ETFs).

These vehicles are evaluated by their cost and the effectiveness of use. For evaluating costs, items such as management fees, expense ratios, and transaction costs are considered. For evaluating effectiveness, factors such as manager style, tracking error, composition, and liquidity should be the main considerations.

An effective vehicle must be paired with strong execution management. An experienced investment manager with the necessary trading capability in executing and navigating through different liquidity conditions would be key for implementation efficacy.

A growing body of evidence highlights the importance of implementation. Academic research suggests "substantial" dispersion among fund managers and investment firms for trade execution12, with better execution leading to lower costs. The importance of implementation for fund managers is also likely to increase with new market challenges emerging such as high-frequency trading (HFT). Research shows that HFT negatively impacts trade implementation for market participants, and has a notable differential impact on implementation results for institutional traders13. In this challenging environment, effective implementation is critical to preserve overall returns by reducing unnecessary costs and unrewarded risks.

IV. Conclusion

Investors are facing increasingly challenging markets. The good news is that changing market correlations offer up substantial opportunities. As this paper has shown, shifting correlations can be navigated with a forward-looking analytical framework based on macro-market factors. The analytical exercise showed that these factors can help assess cross-asset correlation between equities and bonds, including when and how it may change.

Numerous strategies also exist to benefit from the changing market environment. Whether an investor prefers a conventional or flexible asset allocation approach, opportunities are available. Investors may consider seeking opportunities at a more granular level, as well as selecting fund managers that can implement trades efficiently and effectively in fastpaced markets. As the old saying goes, change is the only constant; however, investors can position themselves to profit in this era of volatility and opportunity.

1 IMF. Large Capital Flows: Causes, Consequences and Policy Response, September 1999.
2 IMF. Global Financial Stability Report, April 2015.
3 Abbreviations: MSCI EM: MSCI Emerging Markets Equity Index; US Treasuries: 7-10 year US Treasury Index; EMBI Global: JPMorgan Emerging Markets Bond Index Global; GBI-EM broad loc currency: JPMorgan Government Bond Index-Emerging Markets in local currency; US HY: US High Yield Index; Commodities-Credit Suisse Commodity Index.
4 Rogers, J., Scotti, C & Wright, J. Evaluating asset market effects of unconventional market policy: A cross country comparison, 2014.
5 Bank of International Settlements. BIS 87th annual report, 2016/2017.
6 Tang K & Xiong, W. Index investment and the financialization of commodities, 2010;
Lombardi, M & Ravazolo, F On the correlation between commodity and equity returns: implications for portfolio allocation, 2013.
7 Bicchetti, D & Maystre N. The synchronized and long-lasting structural change on commodity markets: evidence from high-frequency data, 2012.
8 Data before March 2000 are based on US indices i.e. S&P 500 Total Return Index and Barclays US Treasury Total Return Index. Data since March 2000 are based on global indices i.e. MSCI ACWI Total Return Index, and Barclays Global Treasury Total Return Index.
9 Monthly data from December 1998 to May 2017.
10 Markowitz, H. Portfolio Selection, 1952.
11 The 'efficient frontier' is a group of optimally constructed portfolios that maximize returns for a certain degree of risk or have the lowest risk for a given level of return.
12 Chan, L & Lakonishok, J. The behavior of stock prices around institutional trades, 1995.
13 Tong, L. A blessing or a curse? The impact of high-frequency trading on institutional investors, 2015.

About the Author

Market Views And Insights