Understanding Global Market Correlations

What is correlation among investments?

Correlation, which refers to the relationship among various types of investments, is an important concept guiding asset managers in constructing portfolios.  By choosing investments that are negatively correlated to one another, an investor’s portfolio will comprise investments that should respond differently to market forces, helping smooth overall long-term portfolio returns.

Across global financial markets, individual securities and asset classes are constantly moving – rising and falling in response to different market conditions. Sometimes they move in the same direction, sometimes they head down opposite paths, and other times they move with no discernible connection.

The extent, pace and duration of movements can vary. Shifts in one investment may affect another, or the same underlying force may drive them all in the same or different ways.

The degree to which two securities, asset classes or markets move in relation to each other is known as correlation. Correlation is measured by a correlation coefficient. The extent to which different investments are correlated is measured by a correlation coefficient on a scale from -1.0 to +1.0.

It’s important to understand that correlations are not static. The relationship between securities, asset classes and markets changes often (and sometimes rapidly) owing to fundamental or technical factors.

Correlation scores and their meaning

• Scores from 0 to 1.0
  Investments are positively correlated, meaning they are likely to move in the same direction in response to market events. A score of 1.0 is described as a perfect positive correlation and the investments should always move in the same direction.
• Scores from -1.0 to 0
  The investments are negatively correlated. As such, they should move in opposite directions in response to market triggers.
• A score of 0
  There is no correlation at all between the two investments. In practice, this means they are just as likely to move in the same direction as they are to move in the opposite direction.

Why is correlation important?

Many investors understand the concept of diversification and the role it plays in managing risk within an investment portfolio. It is also important to know how investment professionals use correlation figures to achieve diversification and manage risk.

However, when there is a high level of correlation across global markets, it can be more challenging to construct a truly diversified portfolio. In such an environment, asset classes that historically have had low correlation may now represent exposure to the same risk factors. This is referred to as unintentional risk. In these instances, portfolios that appear to be highly diversified may not adequately cushion market volatility.

To manage unintentional risk, investors need to consider diversification of securities held beyond the asset class labels by examining the underlying risk factors that drive returns. For example, investors’ fixed income allocations may expose them to many of the same risks as their equity allocation.

Are global markets correlated?

Across the globe, there are many different degrees of correlation between markets. Some markets are closely aligned, while others vary considerably.

Historically, investors have turned to international equity markets to diversify their domestic portfolios on the assumption that stock markets in other countries would move in different directions at different times.

Indeed, data from Morningstar show that correlation coefficients across global markets (especially for emerging markets) were reasonably stable in the period from 1997 to 2012. For example, the S&P China BMI Total Return Index (in USD) had a correlation of 0.47 against the S&P 500 Total Return Index during the same period. ¹

However, as the world has become more intertwined, correlation figures between markets have moved closer together. With increased globalization, companies are now doing business all over the world which has led to more connectivity across markets.

Correlations have trended up over long periods for some major asset classes, according to Morningstar. Correlations between U.S. and non-U.S. stocks, for example, have significantly increased over the past 10 years. Even areas often touted for their diversification benefits – including real estate investment trusts (REITs) and high-yield bonds – have moved in tandem with the broad U.S. equity market more often than investors might expect. In aggregate, the correlation coefficient for the diversified portfolio versus the Morningstar US Market Index rose to 0.96 for the three-year period ended December 2022, compared with 0.87 for the three-year period ended December 2004, as shown in the chart below. ²