By Indrani De, CFA, PRM; Mark Barnes, PhD; and Christine Haggerty, Global Investment Research
Stretches of extreme volatility such as equity markets have endured since the outbreak of Covid-19 often produce one of the most feared market environments for investors: when stock return correlations spike, diluting the benefits of diversification and leaving investors with no place to hide.
In this regard, this year’s global market selloff has been atypical. Yes, correlations have risen, but not by as much as might be expected given the big upsurge in volatility. As shown below, 12-month moving averages of the cross-sectional industry return correlations for the FTSE Developed index climbed to nearly 0.9 during the market crash in early 2020, virtually obliterating diversification benefits. This year, while both volatility and correlations have climbed, the increase in correlations has been more subdued by comparison and both remain below the levels of the initial Covid-19 shock.
FTSE Developed Index – Volatility and average industry correlations, 12-month windows
Source: FTSE Russell. Data through November 30, 2022. Past performance is no guarantee to future results. Please see the end for important disclosures.
Diverging industry returns come to the rescue
What has been the silver lining in this environment of high volatility and correlations? Amid the extreme risk-on/risk-off swings in sentiment spurred by the pandemic and Russia/Ukraine war, industry performances have been as polarized as they've ever been in a decade. Dissecting the main causes of this uptick in return dispersion can help shed some light on these recent market dynamics.
On a 12-month moving average basis, dispersion in industry returns (as measured by the spread between the best and worst performers) has surged globally since the onset of the pandemic and resulting global market collapse in early 2020. Only the UK has experienced previous periods of extreme gulfs between winning and losing sector returns, coinciding with the Brexit referendum vote in June 2016.
Regional industry return dispersion (maximum vs minimum spreads) – 12-month moving averages (%)
Source: FTSE Russell. Data through November 30, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The initial spike in dispersion across markets occurred along with the March 2020 market crash and the rapid recovery that same year as governments launched massive fiscal and monetary policy support. Return divergences were largely an outgrowth of the collapse in resource stocks (i.e., Energy and Basic Materials) as the global economy came to a virtual standstill and commodity prices plunged, in contrast to the huge outperformance of Technology and other industries benefiting from the surge in demand from stay-at-home and other lockdown restrictions.
These performance disparities receded in 2021, as the rollout of vaccination programs and reopening euphoria fuelled widespread gains across sectors, led by Energy, Financials and Technology.
With this year’s market meltdown, however, dispersion has spiked again in the US, UK and Europe, and remained elevated in Japan, Asia Pacific and Emerging markets. In November, dispersion ranged from 16.6% in the UK to 11% in Japan and Asia Pacific – though, notably, only EM and Europe have returned to their early pandemic levels.
Over the most recent 12-month period, the main drivers of higher global dispersion have been the huge gap between booming Energy stocks riding the surge in commodity prices and the brutal downturn in growth stocks (predominately in the Tech and Consumer Discretionary industries) and Real Estate – all of which have been major casualties of central banks’ aggressive inflation-fighting measures and the rising rate cycle.
As shown, dispersion has been most pronounced in the US, exacerbated by its much larger exposure to Technology (with a weight of 26%) than its global peers, followed by the UK. Over the same period, Japan has exhibited the lowest dispersion.
Regional industry return spreads (%) – 12 months ended November 30, 2022
Source: FTSE Russell. Based on Industry Classification Benchmark (ICB) data as of November 30, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
A focus on the US
Below, we take a closer look at dispersion of returns in the US, the market exhibiting the highest degree of dispersion currently, along with details for several recent periods. Over the full time span, the maximum/minimum spread has ranged from a low of 25% in 2018 to a high of 97% this year so far.
As noted earlier, the gap between the best and worst performers during 2020 was a function of the overwhelming outperformance of Technology (and Health Care) relative to the lackluster returns of Energy stocks. Leadership has made a stunning 360-degree turn in the ensuing periods, particularly this year, when the decimation of expensive long-popular growth stocks and the spectacular outperformance of war-fueled commodity stocks have driven a huge gulf between Tech and Energy returns.
FTSE USA industry returns (%)
Source: FTSE Russell. Data as of November 30, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
As measured by the spread between the best and worst-performing industries, 12-month average dispersion in the US soared to a 10-year peak of 16% in late February 2021 and has remained elevated ever since. That compares with an average spread of 9% (and a previous high of 11%) over the far calmer markets of the preceding seven years.
Implications for industry allocators
The turbulent pandemic years have witnessed among the most polarized performances across stock markets and sectors in a decade. This spike in dispersion poses important implications for asset allocators and active investing strategies: greater dispersion means greater opportunity for adding (or losing) value through stock/industry selection.
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