Thinking about Equity (60%) and Bond (40%) Correlation
In my opinion, the positive correlation is over
The correlation between equity and bond markets has been nearly 1:1 for the past 30 months. Typically, folks opt for government or top-rated corporate bonds to cushion the blows of stock market volatility. Imagine holding a significant chunk of S&P, only to watch it nosedive by 30%—it's a gut-wrenching experience. While the math says "hold steady," fighting that urge to sell can be a real battle. So, many investors go for a mix, aiming for a portfolio where the highs aren't sky-high and the lows aren't rock-bottom, as often seen in stocks. The ideal scenario? When S&P takes a dive, bonds should soar. But this classic inverse correlation has hit a snag in our current market cycle. It's a big reason why the 2022 drawdown hit institutions hard, with the aftermath showing equities bouncing back stronger than bonds—a tough pill to swallow, and we're bracing for the fallout in the years ahead.
The relationship between stock and bond returns is a fundamental determinant of risk in traditional portfolios. For the first two decades of the 21st century, the stock–bond correlation was consistently negative, providing investors with a reliable hedge during equity sell-offs. This trend contrasts with the previous century, marked by macroeconomic shifts, such as heightened inflation uncertainty, which could revive the positive stock–bond correlation seen in the 1970s, 80s, and 90s. Such a shift would have wide-reaching implications, potentially increasing portfolio risk or necessitating allocation adjustments to mitigate lower expected returns.
Why the Bond Market is Regarded as "Smarter"
Market Dominance and Size: Encompassing a vast array of debt instruments including government, corporate, and municipal bonds, the bond market dwarfs its equity counterpart in sheer size.
Institutional Insight: Primarily composed of institutional investors such as pension funds and central banks, the bond market benefits from a longer-term perspective compared to individual stock traders.
Predictive Abilities: Bond markets often forecast economic shifts, with bond yields reflecting expectations on future interest rates, inflation, and growth prospects.
Valuation Precision: Bonds, offering fixed returns and known maturity dates, are generally easier to value accurately compared to the more volatile stock market.
I've got a crew of friends knee-deep in public, private equity, and bond markets. From what I've seen, neither the bond nor equity pros have some magic crystal ball. It's just that bonds are simpler to model—fixed yields, known maturity dates, no surprises like you might find in stocks. You won’t have an issue that behaves like NVDA 0.00%↑ or AMD 0.00%↑ in the equity markets.
Historically, when it comes to reacting to news, stocks and bonds have danced to different tunes. Growth news? Bonds and stocks tend to do the opposite. But inflation news? They nod along in agreement. The secret sauce of the stock–bond correlation isn't the inflation rate but how jumpy growth and inflation are, and how they dance together. This model explains about 70% of the long-term dance between US stocks and bonds, with similar moves seen globally. When inflation's uncertainty starts doing the tango, investors might start beefing up their portfolio with dynamic alternatives like liquid assets and commodities.
Turning to the role of duration in portfolio construction, debates have raged over its impact on investment strategies. Typically applied to fixed-income instruments, duration reflects sensitivity to interest rate changes: rising rates reduce the value of existing bonds, resulting in negative price and total return. However, duration extends beyond fixed income, with certain equities, like technology firms reliant on cheap borrowing, deemed high-duration investments.
Fast forward to early 2022, and both US stocks and bonds were on edge about interest rates. The tech giants, riding high on low borrowing costs post-financial crisis, suddenly found themselves in choppy waters when the Federal Reserve hit the rate hike button in March. Both asset classes took a nosedive, leading to an unexpected twist—a positive stock/bond correlation. Suddenly, the trust in duration took a hit, with worries that this new bond with stocks might not break up anytime soon.
Looking ahead, there's a chance we'll see a return to the good ol' days of a "normal" relationship. Recent CPI inflation figures show a moderation in core prices, even after factoring in those pesky energy surges. This trend toward disinflation might just be what the Fed ordered, potentially signaling rate cuts on the horizon. All eyes are on the Fed's next moves, especially the "dot plot" in their economic projections. The pivot in policy—tightening rates before finding that sweet spot of neutral—could bring back the good vibes of a negative stock/bond correlation. Bonds might pop with joy as rates normalize, while stocks, having seen this coming, might do a little happy dance on the side.
The current positive correlation between US stocks and bonds, among the strongest in years if not decades, hinges on the economy's trajectory this year. Defining scenarios as "hard," "soft," or "no" landings, the landscape for both asset classes remains murky. While a "hard" recession scenario would likely drive a swift negative correlation shift between stocks and bonds, it appears the least probable outcome. Many economists have revised down recession forecasts, citing ongoing job creation and growth expected to hover around 1.5% to 2.0% for the year, alongside robust corporate earnings growth forecasts.
Analysts note that the correlation between rolling 12-month returns on the S&P 500 index and the Bloomberg Treasury index is at its highest since 1997, hinting at a robust yet puzzling relationship. Some attribute this positive correlation to the ebbs and flows of global liquidity since 2008, a pattern that has historically led to swift reversals at extreme levels. This unpredictability underscores the inherent instability of the tight relationship between stocks and bonds.
Anticipating a "softish" landing, where growth slows without a full recession, could offer support to both equities and bonds. However, the exact implications of this scenario remain nuanced, with differing definitions of what constitutes a "soft landing." Experts foresee a return to the long-term negative correlation between the S&P 500 and the 10-year Treasury bond, mirroring historical trends from 1997 to 2021.
In the scenario of a "no landing," initial optimism might buoy stocks as higher Fed interest rates and bond yields could signal robust growth rather than runaway inflation. Yet, this positive sentiment might wane if investors need to recalibrate expectations, especially considering the current futures curve, which factors in significant Fed rate cuts by 2024. Overall, strong growth typically favors stocks unless it triggers an inflationary cycle, a scenario where stocks might initially respond positively until inflation accelerates significantly. This dynamic landscape underscores the importance of understanding the nuanced definitions of landing scenarios and the potential impact on stock and bond correlations in the coming months.
In my opinion, the inflation battle seems to be settling down, which means bonds might take a cue from equities in the next 9-12 months. I predict they'll find stability around the 3.00% mark based on the 10-year US Treasury. The US GDP is looking to grow in the 2.00-3.00% range, with productivity set to take a significant leap. To add to the mix, about half the world is currently facing a recession.
Once the bond market finds its footing again, I'm betting the classic 60/40 portfolio will start showing its strength, especially during times of crises. This equilibrium should bring a sense of balance back to the investment landscape, making for a smoother ride for portfolios in the future.
“Even oysters have enemies.” - Jack Nicholson