In certain sectors, the correlations between equities and bonds are turning positive (again). That is a serious challenge for asset allocators.There is usually a negative correlation between the performance of stocks and bonds. But since the pandemic, a number of sectors, such as tech, consumer and communications, have seen a positive correlation, a recent study by Fidelity International found.
“Traditional portfolios with a mix of stocks and bonds remain important, but investors may look for alternatives to diversify their portfolios if these positive correlations persist,” said portfolio manager George Efstathopoulos. “Possible alternatives include gold, real estate and private assets. But stocks in sectors that still negatively correlate with bonds - mainly financials and to a lesser extent energy - can still be hedged with bonds.’
Negative
For much of the 21st century, correlations between stocks and bonds have been mostly negative. In other words, they move in opposite directions. This allowed asset allocators not only to build diversified portfolios, but also to filter out equity risk to a certain extent by investing in bonds.
But the chart below from Fidelity shows that this correlation is starting to reverse and turn positive in the wake of the deep recession we’ve seen from Covid, and the recovery that followed. That means that when stock prices rise, bond prices follow (and bond yields fall).
The sectors where this is most visible include technology, consumer durables and communications services. Stocks and bonds were negatively correlated across all these sectors, on average over the past five years.
Sustainable?
Ultra-low or even negative interest rates and continued extremely easing monetary policy have pushed equity valuations up sharply, especially of companies with perceived pricing power.The more valuations are driven by gains in the distant future, Fidelity argues, “the more sensitive they become to changes in discount rates, and hence bond yields.” As a result, rising bond yields (and falling bond prices) could also lead to falling stock prices. Not surprisingly, the three sectors where assets are most strongly correlated have the highest cycle-adjusted valuations.
It remains to be seen whether the current shift to a positive correlation will evolve into a long-term trend. Stocks and bonds moving in tandem would mean that it would be more difficult to diversify a portfolio and to hedge risks. Asset allocators will therefore have to be even more flexible and will probably have to rely even more on alternative asset classes.