Correlation Crash – What to Make of It?

Falling asset classes correlation might be perceived as a good thing: lower correlation means it’s getting easier to diversify risk in a portfolio.

The problem is that you have to understand what drives lower correlation among asset classes.

Source: Morgan Stanley

According to Morgan Stanley, the drivers of lower correlation relates to « more divergent policy, politics and currency. »

« Cross-asset correlations have fallen as the traditional rates-risk asset relationship becomes more ambiguous. (…) Falling stock/index correlations seem reflective of the greater idiosyncratic risk, typical in a ‘late cycle’ environment. »

This sounds ok, right ? Well not completely.

« Over the last few years, it’s been common to hedge one asset class with another, given better liquidity and/or lower cost in the latter, and high correlations between them. As correlations fall, the risk that a hedge won’t work rises. »

The key risk for investors is that « any rise in correlation would amplify a move higher in volatility from current levels. »

In such an environment, investors should look at low volatility/low correlation asset classes, which they can currently find in the gold/commodities complex.

« The commodity complex has been very resilient against a backdrop of a rising dollar, and implied volatility is accordingly very muted », write MS’s strategists.