Equity/bond correlation: it’s not always easy
The path to maximum wealth building is to bet the farm on just one security – you just need to pick the right one. Just ask Jeff Bezos or Bill Gates.
Unfortunately, making the right choice is either impossible or just luck with incredibly impossible odds. Ask Christian Gronet (Solyndra) or Julie Wainwright (Pets.com): lesser-known innovative founders who just didn’t make it.
Thus, investors opt for the safer and more reliable plan B to achieve their long-term goals; instead of aiming for the stars, diversify your portfolio by style, geography and especially by asset class. The main component of most portfolios is the diversification of asset classes, mainly the combination of stocks/stocks and bonds.
The basic reasons for combining stocks and bonds are intuitive. If the economy is doing well, profits increase, which helps the stock market perform well. However, an economy that is doing well is inflationary, which pushes yields up, hurting bond prices. If the economy is doing poorly, the reverse should happen with stocks down and bonds up. Stocks and bonds should be negatively correlated and offer great diversification if combined – the mythical smooth ride. Simple, right?
If only investing were that easy. The fact is that many factors come into play, causing the correlations between asset classes to change over time. Today we are going to talk about correlations between stocks and bonds. For obvious reasons, many upset investors (and money managers) don’t like the fact that stocks and bonds move in the same (positively correlated) direction. Everyone expects some degree of volatility from stocks, but it certainly helps the portfolio during times when stocks go down if your bonds go up. That hasn’t been the trend lately.
It’s easy to see in the scatter plots above the monthly stock/equity returns versus bond returns [the purple line is the trend]. From 2009 until the start of the pandemic in March 2020, monthly returns between stocks and bonds were all over the place and didn’t show much of an underlying relationship. This would be “uncorrelated”, which helps in the diversification of a portfolio as the two assets behave rather independently. The second chart shows that the relationship from the start of the pandemic until now shows a different pattern with only two months where stocks were up and bonds were down. And there are many months where stocks and bonds have been lower or higher together. Again, this offers less diversification benefit if they are moving in the same direction.
So, have market dynamics changed to offset the benefits of combining stocks and bonds in a portfolio? Not so fast. First of all, there are so many strange dynamics in the markets today given the lingering repercussions caused by the pandemic, so jumping to conclusions is not a good idea, especially when throwing away decades of data because of… about a year. The point is that the correlations change over time and are currently more positive.
Truth be told, correlations between stocks and bonds have been positive for a few years now, not just in 2022. No one cared about the positive correlation when stocks and bonds moved together. As you can see in the chart above, from 2000 to 2020 correlations were low or negative for most of that time. This was not the case in the 1990s or before.
If correlations are to remain high, does that negate the benefit of stock and bond diversification? No. This may dampen the benefit, but correlation measures direction, not magnitude. This is where Beta comes in, measuring the degree of movement in stocks and bonds (see the thin black line in the chart above). Over the past two years, the correlation between bonds and equities has risen to around 0.5, but the beta remains low at around 0.2. This means that if your stocks fall 5%, bonds should fall 1%. Since a 1% drop is better than a 5% drop, there is always an advantage.
The strong correlation will not stay high either. One factor that seems to have a strong relationship with the stock/bond correlation is the variability of central bank rates. When central bank rates move, the correlation between stocks and bonds tends to be much higher. When central bank rates are stable, the stock/bond correlation tends to be much lower. It certainly makes sense. Changes in the central bank’s overnight rate change the risk-free rate, either up or down. The risk-free rate is a component of the valuation of stocks and bonds, so changes affect both asset classes in the same direction.
Impact on portfolios
The outlook for central bank rates certainly points to continued action in the ongoing fight against inflation. The bad news: this will help keep the stock/bond correlation higher. However, a higher correlation is not always bad. When inflation starts to pick up, the market will likely start pricing in a cooling in the overnight discount rate, which could very well push up stock and bond prices simultaneously — positively correlated.
The yin and yang of stocks and bonds are not broken; maybe people just thought it was a hard or constant rule instead of a time-varying relationship. The benefits of diversification between stocks and bonds may not be as strong as in years past, but they will be again. Definitely explore “new” diversification strategies, but don’t change the core of portfolio construction because of a few years of data. Also, buying bonds that yield 5% seems much safer than buying them a few years ago when they only yielded 2%. Bonds are starting to look like the ex you broke up with, but they’ve since worked and improved their sense of style dramatically – never say never!
Source: Charts sourced from Bloomberg LP, Purpose Investments Inc. and Richardson Wealth, unless otherwise noted.
Any opinions expressed herein are solely those of the authors and do not represent the views or opinions of any other person or entity..