Correlation collapse: Ripe for stock picking

Stock correlations are now at their lowest level since the GFC in 2008, prompting a seismic change in the investor landscape and a more favourable, less constrained market backdrop for stock pickers. Until last year, there were long periods of high correlation – challenging for both active managers and anyone looking to diversify portfolios, as stocks tend to behave in a similar fashion. It can be difficult for investors to find opportunities (particularly value investors) when stock correlations are high, as market performance is generally driven by a single factor.

But when stock correlations fall there is an allowance for greater idiosyncratic differences to influence stock performance. The recent fall indicates that investors are now focussing on company fundamentals over macro noise, which has not really been the case since the GFC. This, coupled with heightened dispersion (a common affiliate of correlation, measuring the difference in performance amongst sectors), provides a more accommodating environment for active, bottom-up stock pickers.

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What has driven this change in environment?

Improving economic data together with increased inflation expectations, rate raises, cuts in oil production, currency shifts and now Trump’s potential policy changes have boosted various investor sentiment gauges and equity markets globally. This has coincided with an improvement in corporate earnings (particularly within the US) and now improving capex forecasts – despite an elevated level of policy uncertainty this year.

The Brexit vote in the UK and the election of Trump as President in the US have helped to widen the dispersion within certain sectors and asset classes, promoting the rotation from bonds to equities and defensives to cyclical sectors for example. So whilst sector allocations may continue to provide exposures to political uncertainties, lower stock correlations should provide a reassurance to active management highlighting the critical role that active managers play – 2017 could be the year we see a renaissance in active management!

Time will tell whether this shift is structural or temporary and any spike in political uncertainty could send correlations higher; but for now stock pickers should take advantage whilst equities continue to move independently from each other and strike while the iron’s hot!

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