Capital markets: The return of relative value?

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Normalization could be back in markets before we know it.

Global financial markets have been in the grip of an almost schizophrenic risk-on/risk-off mentality, by which investors have focused on single systemic threats to global financial stability.

Thankfully, this could be beginning to dissipate at long last.

One of the positive consequences of the US Federal Reserve’s tapering – or winding down of its asset-purchase programme – and expectations of liquidity withdrawal appears to be that investors are edging away from this type of flip-flopping mentality.

A good indication of this is the fact that realized correlations within asset classes (and particularly equity indices) as well as across them have been falling since 2012.

For example, the correlation of the EuroStoxx50 index, the S&P GSCI index, and a range of bond indices versus the S&P500 have been coming down since the start of the year, both for those asset classes that were positively correlated with the US stock market and for those that were negatively correlated.

This, according to Lombard Street Research, opens up opportunities for investors to start focusing once again on relative value and long/short strategies, something that had become much less profitable and often painful in recent years as central banks’ policy decisions were all that mattered.

It’s not that central banks have become irrelevant, but Lombard points out that the growing importance of fundamentals to investors is a positive development, and one "that signals further normalization in financial markets".