Beware of the 'Great Correlation'

- "Throughout the crisis, there has been an increasing level of market correlation, in particular in times of panic. This tail dependency can be found on the level of different asset classes (stocks vs. credits vs. rates vs. exchange rates) but also on the level of individual assets. The central message can summarized in the following way: If everything is going down the drain, really everything is going down the drain. In this publication we focus on the elevated correlation in current markets and its potential implications. Moreover, we describe a simple model that allows to quantify the "average" correlation within a portfolio."
Macro Outlook: "A double-dip recession scenario is not our core view, but the latest
battery of early indicators revealed an astonishing congruency in the slowdown of the headline readings across economies."
Micro Fundamentals: "As the global growth momentum has peaked, we are likely to
observe higher variability in sector earnings and greater dispersion in sector spreads in the near future."
Debt-Equity-Linkage: "Given a significant rise in risk aversion, the level of correlation
among equities also jumped to new highs. The "average" correlation of single stocks within the EuroStoxx 50 index increased above post-Lehman levels recently."
Credit Quality Trend: "The subdued growth outlook brings about great uncertainty
regarding future default rates, due to the correlation between default and economic cycles."
Market Technicals: "While fundamentals are key in the long run, new bond supply and liquidity are a major driving force for credit markets in the short to medium term."
Valuation & Timing: "On a tactical time horizon, the next big topic is the 2Q10 earnings release season, which will keep investors busy over the next few weeks. While for nonfinancials, earnings will probably be in line with OK-ish expectations, earnings data for European financials will meet more scrutiny from investors."
Other Credit Markets: "Credit Derivatives: The relationship between credit spreads and the exchange rate has an impact on the pricing of credit risk in different currencies.
Securitization: in the wake of the sovereign debt crisis, ABS issuance has become scarce again due to high spread volatility. EEMEA Credits: Uncertainty about the outcome of the euro zone debt crisis led to a re-coupling of EEMEA corporates with global credits."
Allocation: "We reduce our sector recommendation for Basic Resources to MW from OW. With this step, we continue with our de-risking strategy that we announced last month: we missed an opportunity to reduce exposure to this more cyclical sector, however, we were reluctant to act in the middle of a panic. All other recommendations were kept unchanged."
Model Portfolio: "Our financials portfolio underperformed the benchmark by -64bp, while the non-financials portfolio outperformed by 11bp due to the recovery in cyclicals."
Unicredit Euro Credit Pilot July2010

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