Friday 14 August 2015

Charts of the Day - Positive correlations and large Standard Deviation moves

"The least initial deviation from the truth is multiplied later a thousandfold." - Aristotle

The Charts of the Day we have chosen to display reflects our concerns relating to the relationship between rising positive correlations due to the "divine" intervention of our "generous gamblers" aka "omnipotent" central bankers and the significant rising "instability" à la Minsky it entails. This can be ascertained from the rise in +/-4 standard deviations moves or more in various asset classes. 

The significant rise in these large standard deviation moves can be seen in the chart below from Bank of America Merrill Lynch European Credit Strategist note from the 11th of August entitled "The liquidity paradox":
"Chart 1, above, refreshes our “correction counter” that we first published in May. It sums, over time, the number of instances that assets in our sample register +/- 4SD moves. The chart shows that asset classes more directly impacted by central bank policy (such as government debt and currencies) are indeed seeing a relative rise in the number of “corrections” over time. But assets where central bank policy is a less direct driver of performance (such as equities, where the growth outlook is arguably key) are seeing “corrections” increase in a more linear fashion.Why might the era of high central bank help be, perversely, resulting in more market corrections? We argued in May that the cumulative result of so much monetary policy support is that the market’s emotional gap between fear and greed has narrowed." - source Bank of America Merrill Lynch
This pattern was expected given following the Great Financial Crisis (GFC), positive correlations have been rising between different asset classes, a subject we discussed again in May this year in our conversation "Cushing's syndrome" and leads us to use once more to use the below IMF chart in the light of Bank of America Merrill Lynch standard deviations move chart above:
"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.
Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:
- source IMF, April 2015
This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoils, bond prices and equities are all moving in concert.
"Positive Correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson
We could not agree more with the above. Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). When it comes to rising risk and the threat of "positive correlations" and Cushing's syndrome we read with interest Nomura European Strategy note from the 6th of May 2015 entitled "At the mercy of macro":
  • "The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. This is the first time this has happened since 2006 and the difference between the two correlations is the largest than at any point in the post 2000 era.
  • The average pairwise correlation between stocks in Europe is close to its post Lehman low. However, we do not think that this heralds the return to some kind of stock-picking nirvana (if such a thing exists).
  • The rapid move up in bund yields and EUR-USD reversals of recent weeks has been felt in some sharp factor reversals, most notably an underperformance of Momentum both across the market and within sectors.
  • We have moved away from a world where changes in macro variables cause short-term rallies and corrections in the overall index level, to a situation where the same macro variables are the driving force for groups of stocks within the market. So understanding the macro risks is no less important. This perhaps represents a market where the main focus is on the nature of the recovery and the timing and type of earnings growth rather than macro developments prompting a continuous existential crisis as we have seen in recent years. We take this as a positive development." - source Nomura
No offense to Nomura but, we do not take it at all as a "positive development". On the contrary, we think it is representative of the excess of "alkaloids" use leading to Cushing's syndrome and rising instability as posited by the great Hyman Minsky." - source Macronomics, May 2015.
As a reminder:
"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

We would like to repeat what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices." 
Expect more violent moves going forward as a consequence. For us, there is no "Great Rotation" there are only "Great Correlations"...

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums." - Alan Greenspan
Stay tuned! 

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