INVESTMENT FOCUS-Herd scatters again as correlations weaken

LONDON, April 5 Fri Apr 5, 2013 10:26am EDT

LONDON, April 5 (Reuters) - The investment herd is scattering again in a sign of less stressful times, encouraged by resolute central bank protection even if scarce growth and jobs may deter funds from straying too far.

One of the defining features of the crisis of the past six years has been hyper-correlation of global markets - where assets as diverse as equities and commodities, high-yield debt or emerging markets moved in lockstep as fears for the stability of the global financial system ebbed and flowed.

Investment decisions everywhere became binary, captured by a dominant swing between 'risk on' or 'risk off', or RORO for lovers of acronyms, on developments as far afield as Athens, Beijing or Washington.

The metronome looks to have broken down in 2013 however. Investors appear convinced by 2012's open-ended commitment from the world's three biggest central banks to do 'whatever it takes', in European Central Bank chief Mario Draghi's phrase, to stabilise financial systems and reflate depressed economies.

The Bank of Japan's super-sized boost to its yen-printing asset purchases this week was just the latest instalment.

Just how far the tone has shifted is illustrated by the way different assets and national bourses are now trading on their idiosyncratic merits, valuations, or problems rather than riffing off each other on overarching global concerns.

What's more, events such as February's inconclusive election in Italy or last month's messy Cyprus bailout stirred only minor ripples across world markets which just a year ago would probably have stampeded investors toward exits across the globe.

But the pattern has broken down everywhere. Wall St's nine percent gains to record highs or Tokyo's 21 percent stocks surge while the yen plunged stands in contrast to net flat euro zone equities, or a 2 percent drop in emerging market stock indices or about 5 percent losses in commodities and oil.

Unlike recent years, there's no one overarching narrative or theme driving these moves - beyond a generalised reduction in stress and volatility.

Crunching the data shows cross-country equity correlations over 24 countries fell to their lowest since late 2008 in the first quarter while high correlations between the euro/dollar exchange rate and other equity, bond and commodity asset groups were at their lowest in about two years. (See graphics)

"We're seeing a much bigger dispersion of returns this year, certainly within the likes of emerging markets, and people are more willing to latch on to national stories or policy directions," said Percival Stanion, who runs more than 8 billion pounds ($12 billion) in multi-asset strategies for Barings Asset Management.

"For us 'risk-on, risk-off' ended last summer with Draghi's euro pledge that broke the link between banking collapses and euro survival," said Stanion, adding "whatever it takes" policy tilts from governments everywhere would only increase as a lack of growth and jobs becomes a serious electoral threat.

Other funds echo that, with Edinburgh-based Standard Life Investments saying this week it was examining more individual country risks as policy responses vary from economy to economy and building more currency themes into multi-asset portfolios.

"There are strong signs that the binary 'risk on-risk off' environment of 2011-12 is starting to mutate as the worst tail risks fade," said SLI economist Douglas Roberts.

Credit Suisse strategists said the way markets shrugged off euro zone risks in the first quarter marked a "profound change" in sentiment. "We feel that the gradual 'normalisation' of investment flows seen over recent months is set to continue."

JUSTIFYING DIVERSIFICATION

For the big institutions who believe broad diversification of pension, insurance or endowment portfolios across many assets and countries is the best and safest long-term strategy, high correlations of the past six years have been a disaster.

These exaggerated the countervailing dash for 'safe assets' over the period and also accelerated demand for less correlated 'alternative' assets such as private equity or hedge funds or real estate and infrastructure.

A sustained easing of correlations now may well tempt them back to more traditional risk assets like equities, even if conservative funds will be slower to declare that the coast is clear and will want to see far more "normalisation" first.

"De-correlations will help equities but it is not a game-changer," said Lars Kreckel, Global Equity Strategist at Legal & General Investment Management.

What's more, HSBC strategists, whose 'RORO' index on cross-asset and cross-border correlations fell sharply in the first quarter back toward late 2008 levels, are also reluctant to sound the all clear just yet.

The bank's quantitative analyst Stacy Williams points out that there have been at least three false dawns like this since 2008 where the index has bounced back sharply again. And at the end of March, it still remained far above pre-2007 averages.

Williams stressed that low volatility in key drivers such as U.S. equities was an important aspect of weakening in correlations and had amplified idiosyncratic behaviour in other assets. As a result, the key test of a return to more normal conditions would be how correlations reacted to any sharp jump in market volatility itself and the jury was out on that, he said.

"Everyone probably wants the 'risk on/risk off' world to end because they're bored or frustrated by it and want to get back to using their expertise in specialist areas," said Williams. "But I think everyone also knows this could all return again pretty quickly."