Understanding the correlation between various asset classes is crucial for investors aiming to build a diversified investment portfolio. Correlation measures the statistical relationship between the price movements of two assets and can have a profound impact on portfolio risk and returns. In this interview, Bruce Liegel, a macro fund manager and author of Global Macro Playbook, explains the factors that drive the correlation between asset classes.
Can you walk us through what drives correlation between different asset classes, and how asset classes tend to move with global macro factors?
Liegel: Traditionally, asset classes tended to move on their own weight and on their own fundamentals. But with central bank money printing over the last 20 years, and with globalization, asset classes have become more intertwined. The term “risk on risk off” really drives all asset classes now. There are days of differing movements in different asset classes. But what happens now is assets tend to be more correlated. When people want to add risk, they buy a plethora of asset classes, they just don't buy one anymore. They may buy oil, they may buy equities, they may buy gold, they may buy other commodity baskets for risk on. And then the same thing comes on risk off. When people want to take off risk, it tends to go across all asset classes.
Central Bank money printing has also caused asset classes to be highly correlated. There's just so much money flying around the system, and only so much money could go into one bucket so they had to find other buckets. That made all markets highly correlated and they all tended to move together. So you had commodities moving together, equities moving together, institutionalization of commodities by having a Bloomberg commodity index or a CRB index. What happened is that when people want to invest in commodities they would just say, "I want to buy the benchmark." And they would throw $10 billion across the board from hundreds of investors, and go into a pool to buy one of those indices.
Let's use the Bloomberg Commodity Index as an example. But what happens is that money goes into buying that index. That index then buys 15 to 20 different commodities. So it doesn't really look at the fundamentals. You have all this money getting pushed in, and so they buy corn, wheat, hogs, cattle, sugar, coffee, cocoa, cotton, aluminum, zinc, copper oil, gasoline, distillate, fuels, natural gas. They're all part of these benchmarks.
So rather than commodities trading on individual fundamentals, the money just overwhelmed the supply and demand dynamics. You could have a weak commodity based on fundamentals. Maybe the day the report came out that said there was too much sugar, maybe sugar went down that day. But then the next day, more money would be flowing into these benchmarks and pushing them up again. So you had huge correlation between commodities and then at the same time, there is so much money flowing around and going into other areas. All asset classes all of a sudden became highly correlated.
Now, we'll probably see that in the next supercycle and commodities where a lot of money will just get put into benchmarks again and they'll buy all of these commodities. There are some astute funds that may just pick and choose which commodity they want to buy. They don't do a benchmark. Maybe they're oil centric, they just trade oil, or maybe they're base metal centric.
So you can invest in funds that are more centric. But on the broad base themes, a lot of pension funds, endowments and other institutional players will typically invest in the whole basket. And that makes those very correlated. The same thing on equities. All that money flows in, they buy the S&P 500, and they buy the whole basket. So it's the same thing. So because of indexing markets have become much more correlated. And really, that has been going on for the last 15 to 20 years. Also the reach for yield probably also made a lot more correlation between different asset classes, whether it was in commodities, whether it was in equities.
How do you see this correlation evolve going forward?
Liegel: Going forward now with higher rates and rate normalization, we're going to see assets trade a little bit more independently of each other. You still have the risk on risk off days where the whole market decides to flush out or add risk. But what happens is you're starting to see more dynamics in play here.
You're starting to see growth versus large cap plays differently, versus commodities or interest rates. This year, the core seven stocks in the NASDAQ have really driven the market while the rest of the stock market has languished. We've seen some commodity prices do really well and we've seen some commodity prices do really bad this year. So we're starting to see the impacts of quantitative tightening and higher rates take that money out of liquidity out of the system. And now markets are trading a little bit more fundamental than they have over the last five or 10 years.
Does the geographic location of an asset contribute to these correlations?
Liegel: Without a doubt. If you can break down the geographic component to emerging markets and developed markets. Emerging markets tend to all move together. Now again, you do have some breakdown between countries based on fundamentals in the country or maybe geopolitics that are going on.
But those correlations are very obvious when you have risk on risk off. When you have risk on, a lot of money can flow into emerging markets, whether that's Mexico, Brazil, other countries around the world, South Africa. And when risk is off, they pull it all back out again. That correlation is going to start breaking down again a little bit. EM always has that risk on risk off feature. I don't think that's going to go away. When people want to put risk on, they'll still look and play different types of EM markets, whether it's by currency or whether it's by equities in those countries, or fixed income, or maybe even commodities when you start talking about platinum in South America, copper in Chile, or soybeans in Brazil. But I think net, net geographically, you do see a lot of correlation, especially on the EM part of it.
Related Readings:
Commodities as an Investment Option
The Institutionalization of Gold
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.