Recession Prediction: Dominoes Are Lined Up

Posted On June 19, 2018 12:57 pm

While large cap tech stocks have far and away been the market leaders, one of the features of the bull market over the past year has been healthy rotation among sectors.

From financials, to energy to retail, each group has had a period of outperformance.  This passing of the baton is not only a sign of broad participation, but has also given a chance for specific sectors to rest or consolidate while the overall market continued on the upward trend.

The decrease in correlation gave stock pickers a chance to shine against their benchmark indices.

But now a report from Morgan Stanley shows a significant increase in correlation, not just among stocks but all asset classes, suggesting the dominoes are lining up for a market fall.

Here’s the report via Bloomberg:

While on-again, off-again risk aversion is the mantra for global markets in this age of trade spats, here’s a sign that the latest flight to safety may endure beyond Donald Trump’s next tweet.

A Morgan Stanley index that tracks correlation among regions and asset classes has reached its highest level since December 2016, a possible signal that the market’s defensive positioning could prove more lasting, according to a note from Tim Emmott, executive director at Olivetree Financial Ltd.

“The fact that this index is trending higher currently could well be the true signal for market players to realize that current multi-asset moves toward risk aversion may be more than short-term,” according to the note.

So far this year, flights to safety have occurred in short-lived bouts spurred, for instance, by the latest twists in trade tensions, without much of a domino effect across asset classes. The VIX Index still sits at its five-year average, while Treasury and currency volatility measures are far below their norms. It’s allowed investors to concentrate on asset- and company-specific drivers, keeping correlations low.

That may change as anxiety creeps back into the market. Emmott points to discussions about policy error that have emerged in the wake of the latest Federal Reserve meeting, the continued difficulty the ECB faces in raising

interest rates thanks to macro and political developments and negative data out of China as rendering “the global inflation trade questionable at least.”

That’s spurred selloffs in emerging-market currencies and commodities that could spread to other asset classes should correlations remain elevated, he said in an interview.

It could also put an end to a stellar year for certain strategies. Macro hedge funds — which bet on economic and political shifts — lead all fund types in performance year-to-date, according to data from Credit Suisse Group AG. It’s a feat they haven’t accomplished since 2011, and they owe it to divergences between asset classes and regions, according to strategists at the Swiss bank.

“Taking the Morgan Stanley Global Correlation Index as a proxy, it would appear that the trade is breaking down,” Emmott wrote. “The move in correlation here may be the canary in the coalmine for the medium-term trajectory of real systemic risk to markets.”

 Related: Are Markets in Denial About the Risk of Recession? 

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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