Anyone who’s been involved in financial markets since the GFC will be familiar with the term “risk on, risk off”, a scenario where financial assets that are either deemed to be “safe” or “risky” move in the same direction.
It used to be dominant during the QE era as massive amounts of liquidity sloshed in and out of asset classes, depending on the prevailing market mood.
However, the the correlation between asset classes has weakened in recent years, as seen in the chart below from Bank of America Merrill Lynch (BAML). The red dots indicate high cross-asset correlation, while the blue ones signal low synchronisation of moves.
With financial markets now increasingly being influenced by idiosyncratic risk, not broader market risks, BAML says that doesn’t mean investors should be come complacent about the potential for weakness in one asset class to spillover into another.
“Monitoring correlation to avoid contamination risk and loss of diversification is important, especially late in the business cycle when the underlying fundamentals become increasingly vulnerable to risks,” it says.
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