The equity-bond dilemma


10 Jun 2024

The equity-bond correlation is in positive territory, but that is likely to change, says Andrew Holt.

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The equity-bond correlation is in positive territory, but that is likely to change, says Andrew Holt.

One of the big points of investor discussion has been the correlation between bonds and equities. The investor consensus is that the correlation should be negative. But that has not been the case more recently.

In fact correlations have sharply increased. Indeed, correlations between stocks and bonds edged into positive territory in 2021 and jumped up to 0.58 for the full year in 2022 and 2023, according to Morningstar.

The uptrend in correlations has been unusually dramatic but not unprecedented: as the stock-bond correlation has often been positive over multi-year periods, Morningstar said.

For example, the trailing three-year correlation co-efficients between equity and bonds were consistently above zero from August 1966 to August 1974, according to Morningstar. Stock-bond correlations were also consistently positive from October 1974 until late 2000.

William De Vijlder, group chief economist at BNP Paribas, said since 2000 the correlation has been predominantly negative, especially when official interest rates were at the zero lower bound.

Then during the Federal Reserve’s latest tightening cycle, the correlation turned positive again, De Vijlder said. “This is reminiscent of what happened during the rate-hike cycle of 2004 to 2006. This is not a surprise: higher official interest rates cause an increase in bond yields and a decline in bond prices,” he said.

Higher rates lower the net present value of future earnings and can cause a downward revision of these future earnings, and weigh on the risk appetite of investors, De Vijlder said.

“For all these reasons, equity prices may decline, leading to a positive correlation with bond prices, which have also declined. Investors no longer benefit from a diversification effect,” he added.

A negative correlation means that when equity prices decline, bond prices rise, and hence bond yields decline. Investors invested in both asset classes will benefit from a diversification effect: one asset declines in value but the other increases cushioning the impact of the other. This effect underpins the demand for bonds, even when yields are low.

Correlation inflation

Morningstar also looked at correlations over specific periods of higher inflation, generally defined as periods when year-over-year inflation increased by at least 5% and remained high for at least six months – and highly relevant for the current period. Here, correlations between stocks and bonds rose during some, but not all, periods.

In general, correlations increased the most when inflation was high – in the double digits – and protracted, lasting at least three years. Going back further, the post-World War II era saw an unusually high spike in inflation, but the increase in consumer prices lasted only about a year.

More recently, surging economic growth in China fuelled rising consumer prices in 2007 and 2008, but inflation remained below 6% and lasted less than a year.

The most dramatic correlation upturns took place from February 1966 to January 1970 – driven by low unemployment and surging economic growth – and February 1977 through to March 1980, driven by soaring oil prices and expansionary monetary policies, Morningstar said.

Correlations ended up in a similar range – 0.26 and 0.28, respectively – during both periods. Thanks to the rapidly shifting landscape for interest rates and inflation, the recent upturn in stock-bond correlations has been even more pronounced.

There is a lesson to draw from these patterns, according to Morningstar’s Amy Arnott, which has implications for investors today: the environment for inflation and interest rates has fundamentally changed.

The idea being that as long as the outlook for inflation and interest rates remains uncertain, the correlation between stocks and bonds will probably remain higher than in the past.

Indeed, correlations between stocks and intermediate-term government bonds stood at about 0.6 for the trailing 12-month period through to the end of April this year.

Investors ironically can contribute to this, as they often hold cash over financial assets during a slowdown, leading to a sudden rise in equity and bond risk premia and conditions that push equity-bond correlations into positive territory.

It doesn’t necessarily mean investors should avoid bonds. Stocks and bonds tend to move more in tandem during inflationary periods, but bonds can still provide significant diversification benefits, as well as play a critical role in providing a counterweight and reducing risk at the portfolio level.

But, this picture could all change. “We see the bond-equity correlation shifting back to negative this year,” said George Saravelos, global head of FX research at Deutsche Bank.

This is a perspective shared by De Vijlder. “Based on past experience, one would expect that, as the Federal Reserve starts cutting rates later this year, the bond-equity correlation would turn negative again,” he said.

This could reflect a benign scenario of equities rising due to lower rates, whereas bond markets have already anticipated the policy easing and start to focus on the positive impact of rate cuts on the growth outlook.

A less benign scenario would consist of a rallying bond market because the economy turns out to be weaker than expected – hence causing equities to decline.

“This scenario, in our view, is less likely,” De Vijlder said.


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