Monday, April 4, 2011

Re-coupled global financial markets

Even as the emerging and developed economies appear to be de-coupling from each other, there is growing evidence that their financial markets are getting more closely synchronized. Have the global financial markets become too-interconnected to fail? Are financial markets no longer useful in risk diversification?

An recent study by HSBC draws attention to the growing correlation between different markets and asset classes - equities, bonds, forex instruments, commodities etc - since the onset of the sub-prime crisis. They argue that the financial markets have become entrapped into a binary state of "risk on-risk off" strategy - all the financial market segments have been swinging in unison, believing that either the future is bright ("risk on") or that it is bad ("risk off"). Risky assets move up or down together. They characterize the present market conditions thus,

"1. Risk on – risk off must be the foremost consideration in any trading activity today.
2. Financial markets, and in particular portfolios, are not as diversified as they once were. Risk takers may be holding more risk in their portfolios than they realise.
3. In current market conditions, there is little point trying to understand the nuances between different asset classes, or the relative value within asset classes. Commodities behave like bonds, which behave like equities. They are no longer easily identifiable, uncorrelated trades, which should be borne in mind when developing new trading strategies."

While synchronization of disparate markets and "risk on-risk off" strategy is a feature of financial markets in the immediate aftermath of a major financial crisis, it persistence for an extended period now is causing concern among market participants. It is argued that the depth of blow suffered to the economic confidence has been so massive that the markets are taking much longer to recover its normal features.

The HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes. The dark red indicates strong positive correlation while dark blue is strong negative correlation, while green and yellow represents weak (or uncorrelated) negative and positive correlations respectively. The heat map below represents the normal and generally uncorrelated markets in 2005-06. At this time, correlations were strong only between same types of assets and the large share of assets were uncorrelated.

However, with time, the correlations have strengthened and we now have a strongly correlated market landscape. Observe the more widely dispersed streaks of red - indicating much increased correlations across disparate asset categories.

These correlations are far from static and are evolving over time in response to various triggers that move the markets. The changes in the market can be tracked by observing the changes in this heat map. The HSBC report argues that when normalcy returns, relative valuations between aseet classes will make a comeback and asset allocation and diversification will return.

1 comment:

jampani said...

Thanks for this publishing this article. I've been looking for something like this to prove my hypothesis of what may be going on in the markets. This helps to navigate through the current markets, but the data collection itself is very intense.