Thursday, 31 May 2012

Risk-Off Correlations - When Opposites attract

"Commodities tend to zig when the equity markets zag."
Jim Rogers

Looking at the recent sell-off in broad asset classes with the spill-off from the ongoing European crisis, we thought it would be interesting to look into asset correlation movements during "Risk-Off" periods such as today. We already touched in 2011 on asset correlation during the sell-off experienced in our conversation "Misery loves company".

More recently in our conversation "St Elmo's fire", we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We argued at the time:
"We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern."
Indeed, both SPX and Oil prices are lower, with Oil dropping another 1.67% toady to 86.35 dollars.

We also indicated that Oil prices were poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss and Son Inc.’s chief executive officer as reported by Bloomberg:
"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years."
- source Bloomberg.

Commodities, like in 2011, have experienced some significant retracement in conjunction with equities with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30 last week. The metal was 1.5 percent lower last week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low as well and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg. Even Gold Bullion wasn't spared and declined 1.9 percent last week as the dollar advanced 1.1 percent against a six-currency basket including the euro, which is poised for its biggest weekly drop in five months versus the U.S. currency according to Bloomberg.

Moving back to Oil and SPX, it seems other pundits as well are following the same disconnect between Oil and SPX as indicated by the below graph from Daiwa produced on Bloomberg, wondering:
** 3yr OIL V SPX: SPX to reset? ** Or Oil to bounce?

Truth is, in similar fashion to 2011, positive correlation between growth assets is most notable when investors are most concerned about risk according to AMP Capital's Oliver - source Bloomberg:
By Sungwoo Park and Saeromi Shin -May 31 (Bloomberg):
"The relationship between commodities and equities is the strongest in more than a year and near a 16-year record, as risks posed by Europe’s debt crisis and a global slowdown make the asset categories “more closely intertwined.”
The CHART OF THE DAY shows the 200-day correlation coefficient between the Standard and Poor’s GSCI Spot Index of 24 raw materials and the MSCI All-Country World Index of shares rose to 0.73 on May 25, the highest since January 2011 and near the strongest since at least 1994, data compiled by Bloomberg show. A correlation of 1 indicates the gauges move in lockstep, a value of zero shows there is no relationship.
When investors are most concerned about risk, “positive correlation between growth assets is most notable,” said Shane Oliver, head of investment strategy at AMP Capital Investors Ltd., which has almost $124 billion under management. “Everyone is looking at the same threats to growth, and so they are all selling together.”
The S and P GSCI index declined 4.2 percent this year through May 29 while the MSCI equities gauge gained 1.5 percent in the period. By contrast, the Dollar Index, a measure of the greenback against six currencies, touched a 20-month high on May 25. Investors are seeking safer assets, such as the dollar, as Europe wrestles with Greece’s debt and the possibility of that nation exiting the euro. Also of concern is the slowest economic expansion in about three years in China, the world’s biggest consumer of metals and cotton. Copper slipped to a four-month low last week, while cotton tumbled to a two-year low. Commodities and stocks have become “far more closely intertwined” as resources have taken on a greater role amid China’s economic expansion and increasing consumption in emerging-market nations, Oliver said. In 2000, after a 25-year commodity bear market, resource companies had low weightings in share gauges. “This has now reversed,” he said. When global risks are perceived as limited, “individual assets are largely driven by their own fundamentals and so the correlation between growth assets such as equities and commodities was low,” Oliver said. “In the current environment of heightened macro instability due to debt problems in Europe and the U.S., this is no longer the case. It’s either ‘risk on’ or ‘risk off’ with growth assets moving together.”

In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar - source Bloomberg:
According to John Detrixhe from Bloomberg on the 29th of May:
"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks.
From last year’s low on July 27, the greenback has risen against all 16 of its major peers. Intercontinental Exchange Inc.’s Dollar Index surged 12 percent, higher now than when the Fed began creating dollars to buy bonds under its extraordinary stimulus measures at the end of 2008.
International investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. The U.S. is one of only five major economies with credit-default swaps on their debt trading at less than 100 basis points, meaning they are viewed as almost risk free. A year ago, eight Group-of-10 nations fit that category, data compiled by Bloomberg show."

From the same article:
"The greenback’s share of global foreign-exchange reserves climbed in the last three-months of 2011 to 62.1 percent, the highest since June 2010, while holdings of euros fell to the lowest since September 2006 at 25 percent, according to the latest quarterly data from the International Monetary Fund.
Foreign official holdings of U.S. government debt increased in each of the first three months of 2012, climbing by 3.24 percent to $3.73 trillion in the best start to a year since2009, according to data from the Treasury Department."
- source Bloomberg.

Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet.

"Which would you rather have, capital lined up on your borders, trying to get into your country or trying to get out of your country? We are the capital magnet of this planet and we are the savior for not only people, for not only freedom, but also for capital."
Arthur Laffer

Stay tuned!

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