The low equity-government bond correlation seen since the turn of the century has formed the bedrock of the 60/40 multi-asset portfolio model. However, the correlation has grown increasingly positive in recent times. FTSE Russell analysis shows the correlation coefficient – which measures the strength in relationship between two linear data points – between the FTSE Global All-World equity index and the FTSE World Government Bond Index reached a 10-year peak of 0.86 at the end of March, with 1 showing a perfect correlation, and zero showing none at all. In contrast, the mean coefficient for the decade since 2013 stands at just 0.26. So what does this upwards trend mean for multi-asset portfolios?
Generally speaking, the stock-bond correlation turns more positive during periods where markets are more concerned over inflation than growth.
In a recent article for Lipper Refinitiv, its head of research Dewi John looked at the monthly correlation of equity and bond funds available to UK retail investors over rolling three-year periods. He found that correlations peaked during periods ending December 2009 and December 2022 – with the middle of these time frames capturing the global financial crisis and and Covid crisis respectively.
“What is worth considering is that correlations are at around the level they were at during the global financial crisis, so would likely surpass this in the event of additional market stress,” he warned.
Ian Samson, multi-asset portfolio manager at Fidelity International, said bonds have been seen as a “fantastic and reliable portfolio hedge” since the late 1990s, during times when equities have come under pressure due to growth fears.
“The positive bond-equity correlation today suggests markets are still worried about inflation hurting both bond yields and equities at the same time, with ‘higher for longer’ rates – or even ‘stagflation’ doing the damage,” he explained.
“This may be a more structural phenomenon. Positive bond-equity correlations were actually the norm from the 1970s through until the ‘Golden Age of Central Banking’ and lowflation era started with credible central bank inflation targets in the late 1990s. Bonds were no better than cash – and sometimes worse – for protecting portfolios in that 1970-1997 period.”
He added that markets could be back in a similar era of structural inflation fears as a result of decarbonisation, deglobalisation, demographics and deficits all driving inflationary pressures.
“That isn’t to say investors are doomed – the 1980s were a great inflationary time for markets, it’s just that equities and bonds always rallied together or sold off together. But it has huge asset allocation implications.”
Anthony Rayner, fund manager within the Premier Miton macro thematic multi-asset team, believes the idea of a negative correlation between stocks and bonds being “normal” is false.
He said: “It is true that they were negatively correlated during the period 2000 to 2020 when inflation risk was minimal, which was also the period of QE. During this period, investors became used to bonds diversifying equities and this has driven the narrative that equities and bonds should normally be negatively correlated.
“However, this disinflationary period was unusual. In fact, economic history is dominated by inflationary periods, and equities and bonds are normally positively correlated… It’s important to appreciate this, as if investors believe these two asset classes being positively corelated is unusual, they will tend to believe it will revert to being negatively correlated at some point fairly soon.”
On the upwards motion of the trend over the past year, Rathbones head of multi-asset investments David Coombs said: “What we have seen since 2022 is the unwind of this as rates and the risk-free rate moved higher. Rather than realised or expected economic stress being the reason for a poor environment for equities, essentially the move higher in bond yields was the reason for equity falls and this causality drove the correlation we have seen.
“To us, nothing suggests a structural breakdown in the typical correlation characteristics between equities and government bonds and rather this is a temporary factor driving this anomaly. How temporary is the key question as the equity market seems to flit between trading on expectations for Fed hikes and expectations for US economic weakness. Some days good news is good news and some days good news is bad news.”
How is this impacting asset allocation?
The upwards correlation trend has caused multi-asset managers to shift their asset allocation.
Premier Miton’s Rayner said the current positive correlation had caused enough concern to adjust the team’s portfolios.
He said: “We always look at how asset classes are behaving not how they ‘should’ behave. As a result, bond duration is of limited use currently to diversify equity risk. Hence, we are short to medium duration and are using bonds for income, rather than as a diversifier.
“Instead, we look to a material gold position and a smaller agricultural commodity position as non-equity diversifiers of portfolio risk. Importantly, within equities, it is more important than ever to be diversified.
“For us, for example, we have a material exposure to Japan which is diversifying away from global equity risk. We also have a material exposure to medium-sized companies, in part to diversify from the large tech names which dominates equity markets.”
Elsewhere, Aviva Investors multi-asset portfolio manager Dean Cook said: “From a portfolio managers’ perspective, we have to work harder to find opportunities for diversification in multi-asset funds. This might be relative value trades between different geographies or sectors relative to their market, isolating excess returns from the overall direction of markets.
“We remain of the view that the interest rate hiking cycle is nearing its end, which should have implications for the relationship between bonds and equities, but acknowledge that the journey will continue to be bumpy, and size positions accordingly.”
‘Diversifying the diversifiers’
Yoram Lustig, head of multi-asset solutions at T Rowe Price, said multi-asset portfolios should always be prepared for a positive equity-government bond correlation and diversify further rather than rely on the two asset classes.
He said: “Because the correlation between equities and government bonds could turn positive, we diversify the diversifiers in our portfolios, using a number of defensive methods. For example, we use global high-quality fixed income strategies with their currency hedged to the portfolio’s base currency, instead of relying solely on local bonds.
“In the UK, for example, gilts have done a much worse job at diversifying equity risk than a global, currency-hedged fixed income portfolio over recent years. We also include safe-haven currencies, such as the US dollar, to diversify equity risk alongside bonds. The dollar tends to perform well when risk assets struggle because investors often rush to it at times of stress. Finally, we use active defensive strategies and overlays when appropriate. Those can use sophisticated techniques and derivative strategies to mitigate downside risk.”
He added: “Our current tactical positioning is underweight government bonds. This is less because of the correlation between equities and bonds and more because of the inversion of the yield curve. Unusually, cash offers more attractive yields than long-term bonds.
“While cash does not give a boost to returns during flights-to-quality because of its near-zero duration, cash does help to depress portfolio volatility and preserves capital (at least not when inflation is considered). We will be looking for opportunities to add to government bonds as the yield curve normalises. Government bonds are one of the best asset classes for periods of economic slow-downs or recessions.”
Fidelity’s Samson added: “Today, investors are realising they need to demand a real risk premium for holding government bonds again – hence why the US 10 year yield is around 4.3%, significantly above most estimates for the average cash rate over the next 10 years. This is one reason I am more neutral duration today, rather than aggressively buying these attractive yields. That said, US treasuries – especially TIPS – are starting to embed a very attractive risk premium, which makes them an incremental buy in my view.
“More structurally, investors will have to look elsewhere for protection in their portfolios. Smart allocations to a basket of alternative strategies (for example, trend-following strategies, ‘long volatility’ options strategies, defensive currency overlays, opportunistic commodity exposure) may do more for risk-return than government bonds.
“Investors may start to favour shorter-dated, floating-rate, or ‘duration-hedged’ credit exposure rather than traditional longer-duration corporate bonds. And finally, if the risk parity strategies and ‘balanced’ multi asset funds of the past two decades no longer provide the downside protection investors expect, more dynamic and active asset allocation will be essential.”
This story first appeared on our sister publication, Portfolio Adviser.
