The world of economics and finance runs on equations, models, statistics, back tests and predictive analytics. It seeks out objective causal relationships that can be quantified and verified. Finding hitherto unknown correlations and directing capital to diversify or amplify these is the holy grail of a global investment management community, which combines to spend thousands of hours and millions of dollars on this task every working day.
Correlation is a statistical measure (expressed as a number) that describes the size and direction of a relationship between two or more variables. A correlation between variables, however, does not automatically mean that the change in one variable is the cause of the change in the values of the other variable.
Causation indicates that one event is the result of the occurrence of the other event; i.e. there is a causal relationship between the two events. This is also referred to as ‘cause and effect’.
Let’s look at examples to bring this to life
In theory, the difference between the two types of relationships are easy to identify — an action or occurrence can cause another (e.g. smoking causes an increase in the risk of developing lung cancer), or it can correlate with another (e.g. smoking is correlated with alcoholism, but it does not cause alcoholism). In practice, however, it remains difficult to clearly establish cause and effect, compared with establishing correlation.
Correlation does not imply causation. That is why when we plot two variables, such as the number of people who drown after falling out of a fishing boat and the marriage rate in Kentucky, we can get bizarre examples of a phenomenon called spurious correlation. It would be entirely misleading to associate a relationship just because two sets of data correlate on a chart.
The two most talked about variables in our world – interest rates and inflation
We will all be familiar with the action taken by three of the major central banks (the Federal Reserve, the ECB and the Bank of England) in recent years. Rising inflation, post the Covid pandemic, was a dynamic that had to urgently be addressed, and the tried and tested tool to remedy this situation was tighter monetary policy in the guise of higher interest rates.
Market participants became increasingly fascinated (and still are) by the actions and rhetoric of the US Federal Reserve – in particular – as it rapidly raised rates and waited for the long-established correlation between this action and falling inflation to manifest itself.
This policymaking was applied by numerous central banks around the world – but not all. This brings us to the chart. This plots the rate of inflation across two domestic economies – the Czech Republic and Slovakia – since the summer of 2020, and compares these to the official interest rate set by the central bank of each country. Officials in the Czech Republic adopted an approach very similar to the Fed and rapidly increased rates as inflation climbed towards an eye-watering 17.5%. Their counterparts in Slovakia – facing a similar inflation problem – plotted a different course, leaving interest rates lower for longer and reaching a ceiling of just 4.0%, significantly lower than the level imposed by the Czech officials. Notwithstanding these two different approaches, the end result was almost identical; inflation fell rapidly from early 2023.
Structural, transitory or a coincidence?
Countless commentators have spent time arguing the recent spike in inflation has been a transitory phenomenon and economic conditions are fast returning to ‘normal’; others have a different view, seeing the rise as structural, suggesting something fundamental has ‘changed’. Correlations and causation are at the centre of this debate – however, could something else be at play? Have we simply experienced a coincidence, a surprising concurrence of events, perceived as meaningfully related, but with no real causal connection?
Looking for patterns where there are none is an innate human behaviour, and commonplace within finance. In the world of psychology, this is known as apophenia and is the tendency to perceive meaningful connections between unrelated things. Examples would include seeking out data which validates rather than contradicts a thesis (confirmation bias), or the clustering illusion of finding patterns in a random set of data.
Implications for portfolios
In the post-Covid era, we have seen many examples of well-established macroeconomic relationships breaking down, or at the very least, taking a long time to reassert themselves. The rapid rate hike cycle in the US and a heavily inverted yield curve strengthened expectations for a recession, but instead we saw robust growth. More recently, we have seen a strong US dollar, even as gold has hit record highs, alongside rising oil, gasoline and copper prices – an unusual combination. More typically, dollar strength tends to put downward pressure on commodities.
These shifting market dynamics create a dangerous playing field for those who are looking to make big macroeconomic bets, trying to second guess market behaviour and direction. Instead, in managing our own strategies, we have been striving to take a balanced approach – having seen the potential for a disinflationary boom – or perhaps even now an inflationary boom – while continuing to monitor downside risks.
This has enabled us to deliver a strong start to the year, leaning into our philosophy of prudent participation with thoughtful diversification, powered by a broad range of return drivers.
Russell Waite and Jon Proudfoot
Affinity Private Wealth is a trading name for APW Investors Limited, which is regulated by the Jersey Financial Services Commission. Registered office 27 Esplanade, St Helier, Jersey JE4 9XJ.
