Inter-linkages among different asset classes: Equities and Credit
The end of the Cold War and rise of the Internet in the 1990s was a turning point in increased globalization, leading to increased capital flows across the world. As financial liberalization increased, financial markets got intertwined, and equities in different parts of the world got increasingly correlated. This inter-linkage between different equity markets is now well understood but the inter-linkages between different asset classes (equities and credit, to name the largest asset classes) is less understood. The reality is that VIX (volatility or risk in equities) is very highly correlated with BBB option adjusted credit spreads (risk in the credit market). Equity returns are negatively correlated with increasing credit spreads. This implies that even for investments focused on one particular asset class, it would pay to incorporate signals coming from another asset class. A multi-asset perspective is value additive. It also shows that risk and return are two sides of the same coin, and investors should always be risk aware or be conscious of whether the expected returns are high enough for the risks being taken.