Which asset class is most correlated with covid cases and why?

Author: Forex Live | Category: Education

A look at which asset has tracked the pandemic more closely

OBX
One of the main traits of the markets through the pandemic is how they haven't behaved as usual in a recession.

Higher risk assets like tech stocks have soared, while traditional safe havens have had erratic behavior. It would be comforting for investors to find some kind of pattern related to covid cases.

To illustrate the problem, let's consider the reaction of gold to the arrival of covid on the scene.

As markets across the world crashed, the expectation was for gold to go up. But, it too, was dragged down by the lack of liquidity. Some analysts speculated that if asset correlation was near enough to 1, that portfolio diversity wouldn't help.

The erratic recovery and market interruption

The thing about the covid recession is that it's not market-driven, but policy driven.

An argument could be made that it's an "artificial" or even "political" recession, with assets not responding to the underlying market conditions, but public policy instead. That in turn, interrupts the normal flow of investment capital, as investors try to anticipate what government officials will do, instead of what will acquire value in the future.

For a clear example, let's look at petroleum.

A pandemic would imply a drop in the price of crude, as the standard method to prevent a pandemic is restricting travel. The price of crude dropped as covid case numbers rose.

But it wasn't really a correlation, as the price crash was driven by competition between Saudi Arabia and Russia.

Prices subsequently rose as OPEC finally agreed to production cuts. Then the price of crude eventually rose higher than pre-pandemic levels despite increased covid cases over last winter.

Getting a handle on the trends

Therefore, finding a direct correlation between covid cases and assets is virtually impossible. This is because investors have to filter that signal through expectations for how authorities will act.

The market is affected by the decision of local authorities to close businesses or issue lockdown orders, not the number of cases. Case numbers are simply a guide for whether or not we might see a continuation of lockdowns.

That said, each major economy has different tolerance levels for when to initiate lockdowns.

New Zealand, for example, issued a national lockdown following one case of community spread. The RBNZ responded by postponing a rate hike that had already been priced into the market.

Meanwhile several US states refuse to reinstate lockdowns despite record high case numbers, citing the improved hospital situation because of the vaccines.


Finding the needle in the haystack

However, a direct correction isn't necessary for us to make projections as traders.

If we understand that it's not case numbers that correlate, but the expectation of case numbers which could drive public policy, then we can find some interesting patterns.

For example, let's go back to the NZD. It dropped quite precipitously when the detection of one community spread case was announced.

However, even as cases have risen, the Kiwi has settled back to its previous price level. The "rise" in cases implied public policy would change, and the market reacted. Once the public policy was clear, the market reacted again, even if the case numbers continued to rise.

Risk and safe haven flows

The general consideration is that with uncertainty, safe haven assets would increase in value, while more risky assets would underperform.

Nevertheless, the rise in tech stocks and the decline in gold throughout last winter kind of disproves that notion during the covid era.

Let's look at this from a different perspective of an inverse correlation.

When case numbers increase, there is heightened certainty that central banks will keep policy accommodative in case new restrictions are announced. Rather than see stocks rise along with covid cases, what we see are yields lower with increased cases, particular, "higher risk" yields, such as European periphery and emerging markets.

Where do we find the correlation?

The asset class that is most directly influenced by public policy, and specifically central bank policy, is Forex.

Currencies are also the asset that most closely corresponds to government jurisdictions, like the British pound corresponds to the UK. This is different from a commodity like crude, which responds to global consumption trends. Or a corporation like 3M, which has its larger customer base in the US, but is impacted by supply and logistics issues from China.

It's not that currencies as a whole move in sync with global covid case numbers. But each individual currency has a higher level of correlation with the case numbers in the economy it represents.

To conclude, the different trends in covid spread, policy and underlying economic conditions create a wide range of interesting trading opportunities.

This article was submitted by Orbex.
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