Max Pacella
Investment Analyst
Macro & Markets
12 Mar, 2021

For any multi-asset portfolio, the first steps for most investors will be their asset allocation decisions.
What are my inflation expectations?
How long is my investment objective?
How much capital will be exposed to equities?
What room does that leave for bonds?
How much risk am I willing to take?
Will precious metals smooth out volatility, or should I buy global property for more yield?

Although the questions may be similar across a spectrum of investors, the ultimate purpose each portfolio is ‘solving’ for may be different.

Some investors seek a blend of assets which will provide them the highest capital growth, whilst some want to maintain a more constant return whilst hedging against a sell-off in one particular asset class. There is no “one size fits all” approach, and every individual will be seeking a slightly different financial aim – for the observant reader, we call this “the market”.

Regardless of your objective, understanding how your different asset allocations are correlated to each other is imperative to understanding the risk/reward profile of your portfolio.

Given the context of recent bond market volatility, today we will focus on the correlation between stocks and bonds.

A Brief History of Correlation

In simple terms, correlation measures the degree to which two securities or assets move in relation to each other.

These two assets can be positively correlated (moving up or down in tandem), negatively correlated (as one moves up, the other moves down) or uncorrelated (movements are unrelated).

One prevailing theory, albeit one that has been challenged and proven wrong for specific periods over the last few decades, is that stocks and bonds should be negatively correlated.

You would use bonds to hedge a sell-off in the equity markets, effectively trying to de-risk your equity exposure through an asset class that benefits when the other fails.

Many reading this may be familiar with this way of thinking, or may have employed it in your own investment philosophy.

But this rule is not set in stone, and as economic conditions change so too do the behaviours of asset classes.

In the 2000s, bonds had low yields (as they do now) and rose when stocks fell – but in the years prior, bonds had much higher yields and moved in positive correlation to equities.

The chart below shows the correlation between the S&P 500 and US 10Y bond yields.

Source: Ardea Investment Management

You can see that indeed during the 2000s, the correlation was almost completely negative, stocks and bonds would have moved in completely opposite directions, where bonds exhibited the characteristic of hedging equities.

But over the last century this has not been a stable pattern and can change within a year (see the change between 1999 and 2000).

Fast Forward to Present Day

If correlations are so positive, what has happened to equity markets over the last month?

Like a politician caught up in a scandal, let me make a series of clarifications.

For the last ~15 years, global central banks have tried to spur inflation higher to achieve their targets and in the process kept interest rates low, whilst at the same time anchoring short term interest rates through ‘yield curve control’ (Jesse explains this further in many of his pieces). This kept the negative correlation situation going for some time, until the introduction of quantitative easing (in the case of the US).

But whilst falling economic growth may help bonds whilst hurting equities, inflation is much more egalitarian and impacts these asset classes equally. This is one reason why we’ve seen the drastic shift to long-term positive correlation in the last few years.

Thus far, we have spoken about the equity market as if it is a uniform entity – but what we have clearly seen over the last 12 months is that we’ve been running in a two-speed market. It stands that this stock/bond correlation will not be uniform across the asset classes – as not all bonds are affected equally, neither are equities.

On one side you have Value, which has not been the focus of most global investors due to reduced dividend yields and structural concerns around re-opening.

On the other we have Growth, generally no dividend yields, but offering higher capital appreciation due to being in COVID-resistant industries or being part of a populist global trade.

But when interest rates begin to rise, even if only the long-term rates, then these two asset classes are not affected equally.

If you are wondering why the NASDAQ has been periodically selling off over the last month, it’s key to remember two things:

  • The market is emotional
  • Its latest phobia is inflation, and mega-cap tech stocks are valued on future cash flows discounted at the levels of interest rates.

If interest rates go up, the company is less valuable in the future.

Source: Bloomberg

In the last month you can see the flip from positive to negative correlation of the S&P 500 and US 10y Treasury bond, and the S&P 500 is made up of ~27% growth-oriented tech stocks (Bloomberg). This is the markets equivalent of cognitive dissonance.

Impacts on Portfolio Construction

In principle, the less correlation between stocks and bonds, the more you are able to properly diversify your equity risk premia through strategic asset allocation.

Conversely, the more correlated stocks and bonds are, an investor needs to seek other asset classes to achieve greater dispersion in portfolio returns.

The issue lays in the positive correlation we have seen on average across the last year.

If an investor wants to hedge against a fall in equity markets, then they must be able to expect that bond prices will rise/bond yields will fall. And in certain sectors (i.e. growth) we have seen that over the last month. But if it is to be a proportional fall in equities versus yields, there is a question of how much lower yields can go – there may be some structural limitations to how negative correlation can go given our current economic environment.

In the interest rate environment of yesteryear, you’d be able to buy bonds as an insurance against equities but still be paid ~5% p.a. – a value that for most justifies the opportunity cost. But if bonds are yielding less than 1%, the return to your portfolio suffers greatly trying to hedge against a risk-off event which may not eventuate.

Much like the equity market, it seems likely that we will see pockets of correlation in certain areas.

If we go back to everyone’s favourite topic of inflation, long-duration, fixed rate treasuries are most at risk of going down in a blaze of glory if we do see a positive inflation shock, whilst Floating Rate Notes (FRNs) or inflation-linked bonds (ILBs) are likely to see significant demand and capital appreciation, since they are a direct hedge to inflation.

And in those winners and losers of bonds, we will see different correlations to stock valuations.

This may be the key to appropriate risk-adjusted asset allocation in future – rather than a broad-based hedge on correlation assumptions, selective sectors should be included in the portfolio which have negative correlation. Think offsetting growth stocks with inflation-linked bonds.

This selective hedging looks to achieve the same effect as a traditional “60% equities, 40% bonds” allocation, albeit with a more focused approach and dynamism around what is an unpresented economic backdrop.

Like a good joke, today’s portfolio construction relies on timing and delivery.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.