Every year, towards the end of December, equity investors tend to look ahead to the New Year with great expectations, counting on a January effect of rising equity markets. Of course they’re very much aware that this statistical ‘rule’ has its exceptions and this year was a big one. Markets have been in the grip of China-related worries and ever lower oil prices. What made the triangular relationship between oil/Chinese equities/Wall Street even more ferocious were the negative feedback loops. The decline in the Shanghai equity market was a reminder of the Chinese growth slowdown challenges, with a negative impact on expected oil demand and hence on prices. This in turn weighed on Wall Street with investors focusing on the negative consequences of lower oil prices: rising default risk in the high yield energy space, negative impact on economic conditions in the oil producing regions (US) and countries. As a consequence, uncertainty has been on the rise, which weighs on the outlook for growth, imports of products ‘made in China’ and oil demand.

Unsurprisingly, correlations have been high as of late. The following chart shows the rolling 30 day pairwise correlations between the Shanghai equity index, the S&P500 and Brent oil.


Several points are worth emphasizing:

  1. Correlations have been fluctuating a lot, thereby changing signs
  2. Since the spring of 2015, the pairwise correlations have been moving together: the correlation of the pairwise correlations has been positive. This reflects the feedback loops mentioned above.
  3. When correlations are very high, they don’t tend to stay high that long. This is in particular the case for the equity/oil correlation and less so for the Shanghai/S&P correlation
  4. Correlations are mean-reverting. The average correlation between Chinese equities and Brent oil is 0.01. Between Chinese equities and the S&P500 it is only 0.28. Of the three pairwise correlations, the one between the S&P500 and oil is the highest: 0.40
  5. January has seen the rather unique situation of the three pairwise correlations close to 1.

As mentioned before, correlations don’t tend to stay very high for long. Based on the news today that Russia is looking for an OPEC production cut, one would expect that the equity/oil correlation would decline. A deal, if ever there is to be one, is still far off, but at least the news today will bring two-way oil price risk into the equation, and this will change the correlation with equities. Although this doesn’t imply a change in sign, it will bring relief to investors who have been tormented so much this month by the impact of the seemingly endless decline of oil prices on equity markets.


William De Vijlder

Group Chief Economist, BNP Paribas

28 January 2016