A shift towards positive correlation between stocks and bonds may already be underway and this phenomenon could persist for many years and be widespread across all global markets if history is a guide, according to Dr Noah Weisberger, managing director in PGIM’s Institutional Advisory and Solutions (IAS) group.
This could lead to a “more volatile world” for those trying to maintain balanced portfolios, Weisberger said, and may force investors to either raise their risk budgets or lower their return expectations.
Speaking in a podcast discussion with Amanda White, director of institutional content at Conexus Financial, Weisberger noted the correlation between stock and bond returns has been negative for the past two decades, allowing market participants for most of–or even all of–their careers to view bonds as a partial hedge for stocks .
But going back earlier to the post-war period, there were 35 years following the mid-60s to around 2000 when stock and bond correlation was positive. Preceding this was a long period of, again, negative correlation.
Investors are possibly conditioned to think of market conditions as higher frequency phenomena, but “this phenomenon – stock-bond correlation being negative or positive – can persist for a really, long time,” Weisberger said.
Predicting a turn in correlation is difficult because it involves a range of different factors and policy levers that can be hard to pinpoint, Weisberger said. Was positive correlation 1965 to 2000 period determined by the oil price shock? Or, was it overly accommodative monetary policy? Or, was it strong productivity growth and the tech bubble?
IAS looks at broad macroeconomic themes like fiscal sustainability, the degree of perceived monetary independence, the degree to which supply or demand is driving the economic cycle, and investor sentiment. These policy and economic conditions “connect very intuitively to…stock-bond correlation,” Weisberger said.
He believes macroeconomic conditions could be pointing to a period of positive correlation: increasing uncertainty about the sustainability of fiscal policy, concerns about the independence of monetary policy, greater volatility of interest rates and the negative co-movement between economic growth and policy rates.
“Those are the things that we think have, in the past, driven stock bond correlation, at least in the US, and prospectively going forward is what could push us into a positive regime from the negative one that we have become accustomed to,” Weisberger said.
White asked if the same factors will apply to global markets or just to the US. Looking at some other developed markets like the UK, Japan and Germany, Weisberger said he was struck by the degree to which developed market stock and bond correlations move together.
“Correlations seem synchronised across developed markets, and there doesn’t seem to be much evidence that any one country leads or is led by any other country.”
Comparing US factors with local factors in other developed markets, IAS found roughly two-thirds of a developed market’s stock-bond correlation movement is due to US factors – in particular, policy risks – and about one-third is due to local economic drivers such as sentiment.
“And, so, like most things in life, the answer is never clean cut and easy,” Weisberger said. “It’s not like CIOs ought to pay attention just to the US, and it’s not like CIOs ought to pay attention just to what’s going on in their local economy. They really need to keep paying attention to both local and global developments.”
Digging into the numbers, the co-movement between economic growth and interest rates is particularly interesting, Weisberger said, acting as a “fascinating summary statistic, if you will, for an investor’s economic intuition of what is fundamentally driving the economy.
To illustrate, he asked: “Is the monetary authority trying to surprise the economy with the degree to which they’re being overly easy or overly tight? Or is the monetary authority responding to the strength or the weakness of the overall economic environment?
“So, none of this is about the level of interest rates, or the level of inflation. In our framework, it’s all about co-movements and more fundamental economic drivers. I think there’s a very important distinction.”
The shift to positive correlation could mean “a more volatile world” from the perspective of a balanced portfolio, Weisberger said, increasing the risk of larger and more damaging tail outcomes.
“Some of the risk metrics that used to be achievable–you know, a certain level portfolio volatility or a certain target Sharpe ratio–may no longer be achievable when you don’t have that extra buffer coming from negative correlation reducing volatility in the portfolio,” Weisberger said. “You just don’t have that anymore.”
Investors may either need to increase their risk budgets or, if they can’t do that, accept lower returns, he said. They will need to look to other asset classes to play the defensive role of bonds, although there are no obvious stand ins.
Investors also need to ask themselves whether they should assume negative or positive correlation in their forecasts, or take a more agnostic approach, he said.