Market Volatility Triggers Reset in Asset Class Correlations
Relatively high return correlations in markets in recent years recede as volatility increases in 2022. As a result, assumptions about market relationships and the degree of diversification benefits may need updating.
In a sign of the times, consider how the rolling one-year correlations have recently changed for three pairs that are widely followed via a set of ETFs: US stocks (VTI) vs. US bonds (BND), foreign developed market stocks (VEA) and equities in emerging markets (VWO). As the chart below shows, all three sets of correlations have fallen more than insignificantly over the past few months on a rolling one-year basis. Note: Correlation readings range from -1.0 (perfect negative correlation) to zero (no correlation) to +1.0 (perfect positive correlation).
For a broader perspective, note that the median correlation of major asset classes has also declined. The current reading of 0.37 (as of March 23) is the lowest in over two years.
The downward bias in the late correlations is also visible at a more granular level. Current figures on 14 ETF proxies for major asset classes show that low and slightly negative correlations now dominate pairings for the one-year window via daily returns.
Even when the time window is extended to a five-year period, it is clear that weak and slightly negative correlations are common.
The change is also visible when moving to one-year rolling returns for a five-year window.
It has been tempting in recent years to assume that correlations are relatively stable and high, implying that modeling that uses this risk metric can be approached with a set and forget mentality. But markets constantly reassess risk and this dynamic aspect applies to correlations no less.
The key question on this front is how much reset will the correlations endure? Unclear, but obvious: whatever you’ve assumed for correlations in the recent past is quickly becoming obsolete.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.