Our head of corporate credit research dives into the question of
correlation and market volatility, and explains why stock indices
can remain stable despite a certain level of turmoil, as we
have seen recently in Europe.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Andrew Sheets, head of
Corporate Credit Research at Morgan Stanley. Along with my
colleagues bringing you a variety of perspectives, today I'll be
talking about correlations, and why they are currently
so important to markets being calmer than they would
otherwise be.
It’s Thursday, June 20th at 2pm in London.
Imagine you’re on a boat, maybe looking for sea life. People are
milling around the deck, watching the vessel ripple
through the waves. Suddenly someone spotsa whale, and
everybody runs to port. The whale swims under
the boat, and everybody now runs to starboard. The boat
rocks significantly.
But imagine the same scenario where marine life
is popping up on both sides of the vessel.
You and your fellow passengers are all now running past each
other in both directions. The movements balance out. The boat is
pretty stable.
Believe it or not, this is how the volatility in the
stock indices work. The individual passengers can be
thought of as individual stocks, and how much they’re each
moving around can be thought of as each stock’s volatility.
The boat is the overall index – say, the S&P 500,
the EuroStoxx 50, or an index of corporate bonds.
When everybody on the boat moves together, what we’d call a
high correlation environment, you’d get a lot of
rocking, or volatility, at the index level. But when people are
moving in opposite directions, moving past each other; you
can still have a lot of running, or individual
vol – but the market, or the boat, will appear much
more calm.
That is exactly what’s been happening, especially last week.
Stocks within the S&P 500 are moving with unusual
independence from each other, running to opposite sides of the
boat, with the lowest such correlation in almost 20
years. That is a big reason why, despite all the volatile
headlines out of Europe, and more stocks falling than rising in
the US, the overall market has been surprisingly calm – and going
up.
Even in Europe, this phenomenon of low correlation has really
helped. That volatility I mentioned relates to upcoming elections
in France, which led the difference between French and German
bond yields to jump to their highest level in more than a
decade.
But because this spread of France to Germany moved in the
opposite direction as overall French yields, the overall result
for French government bonds was not much. Last week, despite all
the apparent ruckus, the yield on French government bonds was
basically unchanged. Markets have been calmer than you would
usually expect them to be.
These correlations are a big reason why.
We think they suggest a still healthy dynamic where markets are
differentiating between different types of risks. To go back to
our original analogy, there is still plenty of sea life out there
for the market to look at. But these correlations are also worth
watching, were they to rise significantly. If one thing were to
dominate the focus and lead everybody to run to the same side of
the boat, overall market volatility could rise surprisingly
fast.
It's something, you could say, that we're on the lookout
for.
Thanks for listening. If you enjoy the podcast, please leave us a
review, wherever you listen, and share Thoughts on the Market
with a friend or colleague today.
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