Empirical evidence suggests that correlation between asset classes tends to spike during a period of market crisis, because investors panic and sell indiscriminately. This phenomenon is usually short-lived and correlation returns to a normal level as the market stabilizes. During the 2008 financial crisis, this effect was amplified by a liquidity shock. Highly leveraged banks were hit by the subprime mortgage crisis and, as their balance sheets deteriorated, they had to start de-leveraging and defensively try to minimise counterparty exposure. This put pressure on interbank funding that quickly spread to other financial institutions. This funding liquidity crisis naturally leads to market illiquidity, with bid-ask spreads widening in several markets, and quoted amounts being reduced by dealers with less available capital. The search for liquidity spreads the crisis to other markets and asset classes, hence raising correlation.
We analysed fifteen years of daily and weekly returns of worldwide major asset classes in order to understand how correlation behaved in the last six years compared to the pre-crisis period. We estimated dynamic conditional correlation and focused on the correlation between the S&P500 and other asset classes.
During the crisis, average correlation between the main asset classes reached 80%, which is consistent with what stated above. Still now, though, correlation is well above its pre-crisis level, and we believe that there has been an upward structural break caused by central banks and regulators’ countermeasures to the crisis. In the chart below, we can see the difference between pre-crisis and post-crisis average correlation between the S&P500 and other major asset classes.
Chart: average correlation with the S&P500 (source: Bloomberg, BSIC)
Let us now try to investigate the possible reasons for such a shift.
Firstly, in order to sustain the economy during the recession, central banks embarked on unconventional monetary policies such as Quantitative Easing. The overwhelming tide of liquidity supplied by central banks and the near-zero interest rate environment have inflated asset prices altogether as investors have been seeking higher yields moved their money on riskier assets. In particular, correlation between stocks and bonds has risen significantly, as the S&P500 has been trading “good news, bad news” lately and prospects of future movements in interest rates have had the same impact on stock and bond prices.
Secondly, in the aftermath of the financial crisis, regulators all over the world started implementing stricter rules for financial institutions, especially banks, in order to prevent excessive risk taking. Specifically, banks were forced to cut inventories of risky assets and their ability to provide liquidity in the market has diminished. As stated above, thinner markets could contribute to higher correlation levels as asset prices are more likely to be driven by common shocks, particularly at higher frequencies, than by their respective idiosyncratic fundamentals.
Finally, another possible culprit might be globalisation. In fact, the advance of new technology and integration between real economies is making financial markets always more intertwined. Moreover, the asset management industry is becoming more linked and concentrated and, therefore, prices in seemingly unrelated asset classes might become correlated simply because the same investors hold them.
In conclusion, we believe that this new correlation regime should persist as it is driven by globalisation and structural changes in financial markets architecture and regulation. Maybe, a normalisation in monetary policies could have an impact on correlation, but we do not see a structural global tightening in the near future; indeed, even if the Federal Reserve were starting to gradually hiking interest rates, other central banks all over the world have embarked themselves in monetary easing policies. Furthermore, we do not believe that there is going to be a deregulation of financial institutions any time soon.
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