- Five-year trailing US equity bond correlation is now positive
- Volatility correlations could be a powerful signal to investors
Diversification is a core tenet of portfolio construction – different asset prices don’t move perfectly in step with one another, so keeping your eggs in more than one basket spreads risk. Furthermore, in line with the observation made in a seminal work by US economist Harry Markowitz in 1952, by holding a diversified portfolio investors can take less risk overall and still achieve their objectives.
Negative correlations between asset prices (i.e. some going up as others go down) are key to modern portfolio theory (MPT). Most important down the years has been the often inverse relationship between equity and bond prices, with the simple asset allocation of 60 per cent shares and 40 per cent bonds (60:40) therefore representing a compelling benchmark.
Periods of exception do occur, however. When post-Covid inflation took hold in 2021-22, the upward pressure on interest rates forced a sell-off in bonds. At the same time, expensive shares were hit as higher bond yields made investors reconsider the valuation of riskier assets.
This structural shift across both asset classes is unusual. In 2022, when the five-year trailing stock-bond price correlation in the US turned positive, it was the first time in 20 years that this had happened. Looking ahead, however, analysis provided by asset manager PGIM suggests a positive relationship over the medium term could persist.
PGIM’s authors stress the difference between positive and perfect correlations – unless share and bond price movements occur with the same magnitude, then diversification still has merit. That said, they also highlight important dynamics in the current macro backdrop.
Potential catalysts for an increase in stock/bond correlations in PGIM's eyes include uncertainty about America’s national debt and the Federal Reserve’s ability to stick to rules-based monetary policy, given the need to manage debt burdens and financial stability. Happier reasons why positive correlations may persist include the reversal of post-Covid supply shocks and renewed productivity growth (due to new technologies such as AI and as a benefit of the government infrastructure programmes).
On top of this, PGIM says that periods of high interest rate volatility – as we may well continue to witness in the months ahead – coincide with positive equity/bond correlations.
Correlations in volatility give us a sign
The IC's own research, focusing on shorter timeframes than those examined by PGIM, suggests indicators that could have value. During stress events, volatility among equities and bonds spikes, and the correlation in this ‘bunched’ period of volatility has previously been a signal to reduce allocations to shares and avoid the worst of peak-to-trough drawdowns.
Studying the MSCI World price index and the benchmark 10-year US Treasury bond yield, using something called a dynamic conditional correlation (DCC) model, we can see how clustered volatility in both assets moves in situ. Spikes in the volatility correlation occurred early on in crises such as the dotcom sell-off, the global financial crisis, the eurozone crisis, the early Covid period and as inflation took hold post-Covid, and the war in Ukraine.
The huge caveat for any model like this – which is looking at a volatility relationship – is it must be used in conjunction with separate indicators for underlying equity and bond prices. This is because although in most cases greater volatility meant a fall in equity prices and a rise in bond prices, inflationary sell-offs are an important exception. At the end of 2021, unlike in previous crises, the best thing to do certainly wouldn’t have been to switch into bonds, unless they were very low duration (low interest rate sensitivity) US dollar Tips (inflation-protected securities issued by the US government).
Back to the underlying assets
Volatility is a good signal, but for investors who aren’t quants and just want peace of mind, strategic asset allocation and being circumspect about risks and uncertainty on the horizon are crucial. That said, although you might not be able to invest like the professionals, you can learn from them. Analysts at Société Générale state that over 60 per cent of the MSCI World index by market capitalisation is now positively correlated to bond prices, which leaves investors “horribly exposed” to another interest rate shock.
Yet with bonds offering potentially good long-term returns, there is a balance to be struck. In response to such quandaries, good short-term asset allocation changes are usually done at the margins of a portfolio.
Keeping a higher than usual proportion of a strategic fixed-income allocation in short-duration bonds is a smart move, but tactically at such times it is worth handing some of the portfolio earmarked for riskier asset holdings over to longer-dated bonds. This doesn’t mean exiting shares, but it could mean shifting 5 per cent from equities, with bonds split between shorter and longer duration.
