Market Commentary | July 19, 2021

Where To Invest Now: COVID And Correlation

Key Points

  • COVID-19 resurgences appear to be the primary driver of moves across many markets this year.

  • Until the COVID-19 case count gets back under control, the yen may strengthen, the U.K. yield curve may flatten, and defensive lockdown-era leaders in the stock market may continue to outperform.

  • Don’t know exactly what will happen next? Diversify. Since many different types of stocks are making new all-time highs, but they are not moving in sync with each other, it can be good news for diversified investors.

With the current news flow, it’s hard to tell exactly what’s driving the global markets’ moves. There is a lot going on! It’s one of the best earnings seasons in history. U.S. inflation is surprisingly strong. The Fed is openly discussing when to rein in stimulus. But the blanket explanation for just about everything happening in the market this year is COVID-19.

Still COVID

2020 will be known as the pandemic year, but COVID-19 is still around and driving 2021, too. New COVID-19 cases, driven by the rapidly spreading Delta variant, seem to be driving the stock market’s rotation this year in relative performance of sectors, styles and countries, as you can see in the chart below. Economically sensitive, or cyclical, stocks have outperformed when the global case count declined and the defensive, lockdown-era leaders outperformed when cases climbed.

Delta driver: sectors, style and country

Source: Charles Schwab, Bloomberg data as of 7/16/2021. Past performance is no guarantee of future results.

 

Across markets

It isn’t just equity markets being driven by COVID-19. Where larger breakouts are taking place, such as those in the United Kingdom and Japan, the rise and fall in cases seems to be driving the bond and currency markets too.

For example, in the U.K., the bond yield curve (the spread between short and long-term interest rates) has moved inversely with the daily number of new cases in the U.K., which are currently back on the rise.

U.K.’s yield curve and cases

Source: Charles Schwab, Bloomberg data as of 7/16/2021.

 

In Japan, officials have declared a state of emergency in Tokyo and banned spectators at the Olympics in response to the latest rise in cases. We have seen moves in the yen align with new Japanese case counts.

Japan’s currency and cases

Source: Charles Schwab, Bloomberg data as of 7/16/2021.

 

What to do

For investors, this pattern implies that until the COVID-19 case count gets back under control, the yen may strengthen, the U.K. yield curve may flatten, and defensive lockdown-era leaders in the stock market may continue to outperform.

Consensus on when the virus may be contained is elusive. If you believe it may take a year or more before cases begin to retreat, then seeking defensive might make sense. But if you believe that the cases may soon be under control, then focusing your strategy on cyclicals may be more attractive. We offered our view two weeks ago in the article Lockdown Leadership Unlikely to Last. As it applies to the rest of the year, we believe that the global economic expansion will not be derailed by COVID-19. But, admittedly, in the near-term, we cannot dismiss its effect on the global market.

What’s the best action if you don’t know what will happen next? Fortunately, our solution is simple: diversify. Many different types of stocks are making new all-time highs, but they are not moving in sync with each other. It can be great news for diversified investors.

As you can see in the table below, new all-time highs have been reached in the past month or two for U.S. stocks, European stocks, all non-U.S. stocks, growth stocks and value stocks.

Stocks of different stripes are all hitting new all-time highs

Source: Charles Schwab, Bloomberg data as of 7/16/2021. For illustrative purposes only.

 

When different types of stocks in a portfolio are moving out of sync with each other, it can lower the overall portfolio volatility because some zig while others zag on their way higher. Historically, stocks have tended to move together, and have a high degree of correlation. A correlation of 1.0 occurs when stocks move perfectly in sync with each other and -1.0 when the move exactly opposite of each other.

Correlation has turned negative and that’s a positive for investors

Source: Charles Schwab, Bloomberg data as of 7/16/2021.

 

Today, U.S. and international stocks are moving out of sync with each other to a degree not seen in many years, as you can see in the chart above. It’s very rare to see a negative correlation, but it can be a positive for diversified investors.

Michelle Gibley, CFA®, Director of International Research, and Heather O’Leary, Senior Global Investment Research Analyst, contributed to this report.