G3 Recap 5-17-11

Main Items:

  • Building Permits declined to 551k in April vs 590k expected and 594k previously.

Overseas:

  • UK CPI rose 4.5% YoY in April vs 4.1% expected and 4.0% previously. Air transport costs and Easter seasonality contributed strongly to the surprise. King’s letter reiterated his view that VAT, energy and import prices contributed to the overshoot, and that “inflation would have been substantially lower and probably below target” without them.
  • German Zew Survey of Economic Sentiment declined to 3.1 vs 4.5 expected and 7.6 previously. The measure for the Eurozone also declined to 13.6 vs 17.3 expected and 19.7 previously

Commentary:

  • BAML Fund Manager Survey:
    Only a net 10% of investors expected stronger global growth in the next 12m vs 58% in Feb. 75% expect no Fed hike before 2012. EU sovereign debt issues have supplanted commodity inflation fears as the #1 perceived tail risk.

  • JPM issued an interesting research report highlighting increased cross asset correlations yesterday. The effects of globalization, stat arb and high frequency trading are being felt across the globe. Some of the correlation increases have been substantial, (charts are below) and I thought it was worthwhile to think through some of the effects. Readers should feel free to add to the list.
    1. Higher portfolio volatility as the benefits of diversification decrease. Higher skew, both positive and negative, for portfolio returns. Portfolio returns will become increasingly ‘lumpy,’ as a major cross asset correction could ‘correct’ valuation levels simultaneously
    2. Steeper implied vol term structures as well as skews.
    3. Lower aggregate HF position and returns. If everything is +/- 100% correlated, they will have to take a smaller number of positions per unit of equity/risk.
    4. Pure systematic momentum strategies will become less profitable in aggregate – payoff will look increasing like a short gamma strategy.
    5. Increased opportunities for Macro RV bets inter and intra asset classes
    6. Having a global macro understanding will become increasingly important, as macro drivers have stronger effects across all asset classes.

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3 thoughts on “G3 Recap 5-17-11

  1. Are those daily correlations? What periods are taken to compute them?

    Such aggregate charts are a bit misleading actually – take the commodities for example. They demonstrate higher correlations between themselves and with equities then before, but I can’t call them high (0.25 to 0.3 would be considered quite low in most fields of statistical application). But if you analyze this on a per commodity basis, you’ll find a small group being highly correlated (oil, copper etc.), some moderately correlated (precious metals) and the majority having very low correlations. So a commodity trader who’s into that last group can still work in a more or less uncorrelated environment. Same argument can be extended for all other asset classes – while on aggregate they are rather highly correlated, you can still find less correlated stuff in them.

    1. True, but I think the general message is still intact. Higher average correlations suggest lower opportunities for diversification.

      6m daily closing prices are used, I believe.

      1. Yes, and more diversification-seeking. And steeper IVs that you mentioned, as there will be more hedging with options.

        Of special importance, though, is the reason for these rising correlations. Mu hunch is they’re driven mostly by monetary factors (i.e. liquidity affecting the financial markets) with quantitative RV strategies as secondary factors.

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