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The Global Recovery Factor

In normal market conditions the price of any individual asset is driven by a multitude of forces relevant to it, but in today’s markets, after the fall of Lehman Brothers, most assets are being driven predominantly by the same single factor – “global recovery factor” coined by the University of Oxford Mathematical Institute, which directly tract its dominance in global markets through RORO (Risk On – Risk Off) Index.

Correlations between assets that historically hardly moved together are now highly polarised, being strongly positive or strongly negative.  Equities, interest rates, energy, commodities and currencies now move in tandem. The benefits of diversification are thus destroyed and the volatility of once low-risk portfolios greatly increases.

Some exceptions are gold and soft commodities, in which they behave some what ‘independently’.  But capacity and investment opportunities here are limited. Even the well-known FX carry trade of buying high yielding currencies while selling low yielders to gain the interest rate differential has not escaped. Carry’s popularity historically has, in part, been due to its returns having low correlations with equities, providing so called “independent alpha” to a portfolio. Today, carry returns are synchronised with equity returns and merely add leverage. They are two expressions of the same global recovery trade.

Correlations are known to go up during crisis periods, but the current phenomenon is in a league of its own. The RORO index shows that correlations are much higher now than they have ever been during the twenty years that data allows meaningful analysis, and they are continuing to rise even though the height of the crisis has nominally passed. We can clearly see that these conditions have been event-led, however, and a sustained absence of unsettling financial events will be needed before normality resumes. Only when talk of quantitative easing, sovereign risk, and deflation starts to fade will we see any change. It would be optimistic to imagine this happening within the next eighteen months.

This factor reflects the great uncertainty in the outlook for the global economy in the coming years. A world where stable growth returns and government indebtedness is brought under control is very different to one where growth falters and sovereign debt problems escalate. Markets are struggling to correctly price in these very different outcomes. Feelings of optimism and pessimism oscillate nervously within the markets and the prices of a whole range of assets move up and down with them.

To an investor, the implications are:

  1. Be wary of any diversification they think they have and seek out the pockets that still exist.
  2. Second, irrespective of asset class, they can focus their energies on the shifting expectations that drive the global recovery trade. The “global recovery factor” can be traded directly through simple but judicious portfolio construction, and healthy returns are there to be had.
  3. And finally, it should endeavour to track the dominance of this phenomenon. For when it starts to wane, as it surely must eventually, investment opportunities right across the asset classes will abound.

Reference:  Financial Times, 20100105. “Risk Trades will test investors through 2011”