Singapore: Cross-asset correlations like that between stocks and bond yields, or commodities versus the dollar, can signal major market turning points. But the conventional wisdom isn’t always right, either.
Investors rotating into risky markets express reservations “typically informed by apparent breakdowns in cross-asset correlations,” JPMorgan Chase & Co. said in an April 5 note that studied which relationships will be worth tracking this year.
The bank’s strategists led by John Normand cited “this year’s jolt in stock prices but drop in bond yields (and US curve inversion) or the significant drop in US yields but only modest decline in the trade-weighted USD plus USD strength versus most G-10 pairs.”
The US equities/credit spreads correlation is worth watching, they said. So far this year, stocks have rallied as credit spreads tightened. JPMorgan expects spreads to widen later in the year as stocks continue to gain. The strategists say that if the phenomenon is driven by deal activity it can be downplayed, and it can be tolerated “for a while” if any eventual Federal Reserve rate hikes are slow.
But another catalyst would be a cause for concern. “If the driver is weak corporate earnings, then spread widening is an early-warning sign worth heeding, as in the late 1990s before equities peaked in 2000,” the report said.
While much is being made of the US dollar’s failure to decline, the “worrisome” divergence around the greenback is the difference between performance of developed-market currencies against it versus emerging-market ones. The dollar gaining versus most major currencies and dropping against most EM FX occurs only about 10 per cent of the time, according to JPMorgan.
“Strong country-specific influences outside the US need to be in play to justify this anomaly, as they are now with respect to Europe and the Antipodeans,” the strategists said. “But this potential de-correlation within currencies bears watching if non-US conditions change.”
Sectoral and style divergences in the equity market, such as cyclicals and growth stocks underperforming defensives and value while the overall market is rising, could be a concern, they said. But those correlation breakdowns “are also more common than many assume.”
Higher stocks along with lower yields bother many investors, but are actually the most common pattern for the relationship and would be more of a concern if activity data were softening, the report said.
Another area not to be concerned about: oil versus the dollar.
“Oil’s strength this year is consistent with the historical pattern of higher prices running alongside USD weakness,” the strategists wrote. “This is the market where we are most inclined to dismiss any apparent correlation breakdown given how central supply conditions are to the oil outlook and how tenuous the link is between currency moves and producer decisions.”