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Since the turn of the century, equities and bonds have usually maintained a negative correlation. That relationship has now turned positive. The question is, will this last? And if so, how might it alter portfolio risk mitigation?
In many multi-asset portfolios, the principal protective relationship is the negative relationship between equities and bonds (duration). Specifically, during times of equity market declines, the expectation is that duration will rally and at least partly offset the loss. However, this year has seen both equities and bonds decline. This positive correlation has turned the equity/bond relationship from risk-mitigating to risk-additive and challenged many multi-asset portfolios.
Perhaps the easiest way to understand why the correlation has turned positive is to think through why it is often negative. Specifically, imagine that the equity market declines due to a deteriorating economic outlook. Markets would, given the experience of recent years, likely expect central banks to cut interest rates to spur demand and get the economy back on track. It is this expectation that has often generated the negative correlation: A worsened economic outlook is negative for equities but positive for duration when the response leads to lower rates.
But this relationship does not work if central banks are also facing inflationary pressure, as they are now. In this case, central banks will be torn between either cutting rates (in response to the worsened economic outlook) or hiking rates (in response to higher inflation). If central banks decide to focus on inflation, as they have so far this year, then bonds will decline along with equities.
Are we more likely to see inflationary shocks and periods of rising inflationary pressures amid a weakening economic outlook than in the past? While it’s hard to make definitive statements, we think so. Many of the dynamics that kept inflation low for years (e.g., globalization) have begun to unwind, making inflation generally higher. As a result, we expect that central banks will be forced to wrestle with a trade-off between growth and inflation that they haven’t seen in decades. If this is correct, then we should expect episodes of positive equity/bond correlation to be more likely going forward.
While bonds can still be protective during disinflationary shocks (when policy cuts are likely), there will be times (during inflationary shocks) when they are not. It is therefore about augmenting the protective role of bonds, not replacing it.
In some cases, this may be achieved by adding structural allocations to defensive exposures (e.g., gold, defensive equities, certain types of hedge funds). But we think another potential part of the solution can be to introduce a process we call active risk control (ARC). This process, which can be a complement to a standard active asset allocation process, seeks to actively adjust portfolio hedges as the perceived probability of a market decline fluctuates. For example, if the probability of a near-term drawdown is elevated, various protective strategies (e.g., options, beta hedging, volatility-control mechanisms) may be implemented to potentially help mitigate some of the downside loss even if the correlation between equities and bonds remains positive.
For more on the shifting macro environment and the need for a broader set of investment tools, see our Mid-2022 Investment Outlook.
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Brett Hinds
Jameson Dunn