- Thematic Strategist
- About Us
- My Account
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Recently, I wrote about the rotation from growth to value and why some of my colleagues and I expect volatility, more than a smooth transition of leadership, to define markets. The thesis is rooted in the fact that seismic macro questions loom over markets and are likely to trigger violent fluctuations in investor conviction. Earlier this month, Macro Strategist John Butler dissected one of these questions: Will the negative correlation between stocks and bonds turn positive?
Since the turn of the century, stocks and bonds have maintained a persistent negative correlation. It is a convenient relationship that has shaped modern market dynamics across asset classes. As Portfolio Manager Mark Sullivan noted recently: “Most large asset holders run some form of risk parity based on the assumption bonds will act as an important diversifier in periods of weak growth and economic stress.” Yet, history attests, today’s sustained negative correlation is an anomaly, not the norm. According to Goldman Sachs calculations going back to 1900, a sustained negative correlation has occurred during only two market regimes prior to the late 1990s, and no negative run lasted more than a decade, nor dove as deep into negative territory as experienced over the past two decades.
Since the pandemic began, we’ve seen the rolling 12-month correlation between the S&P 500 and the US 10-year Treasury bond turn positive. If this proves structural (and therefore, lasting), the cross-asset-class implications would be seismic. It could drive investors to reprice risk across bond markets. It could compromise the “buy-the-dip” mentality that has suppressed equity volatility for years. And it could spike demand for alternative and uncorrelated asset classes as investors seek new paths to diversification.
Regardless of the outcome, the takeaway from Butler’s analysis is clear: Volatility is likely inevitable when market-defining dynamics sit on a razor’s edge. It is a high-risk and high-reward environment, which requires creativity and humility. As Portfolio Manager Michael Carmen sagely advised: “Expand your horizons [and] be careful out there.”
The future of the stock/bond correlation hinges on whether inflation proves temporary or persistent. COVID-driven supply bottlenecks have no doubt exaggerated the inflation spike. However, mounting evidence suggests structural forces could continue to constrain supply across global economies, from decarbonization to a rapidly aging developed world to the backlash against globalization. And if constrained supply undergirds persistent inflation, it will trigger a new central bank policy regime. To quote John:
Since 1999, economies effectively oscillated between two worlds — “goldilocks” (recovery and no inflation) and repair (weaker growth and no inflation). Central banks chased growth. And, as central banks chased growth, there was a negative and stable correlation between equities and bond returns… If supply is more constrained going forward, central banks will go back to trying to manipulate demand as a tool to adjust inflation…Central banks, as a result, won’t be as quick to respond to the first signs of weaker demand. Instead, they will need to be confident that weaker demand is slowing inflation. Their policy response will lag turning points. In the new regime, at times, central banks will become a source of volatility rather than a compressor… In [that] world, equity and bond returns will no longer be negatively correlated, but could spend much of the time positively correlated.
Recently, Macro Strategist Michael Medeiros circulated a chart depicting the staggering collapse of US labor force growth as the pandemic instigated a wave of retirements (Figure 1). As Fixed Income Portfolio Manager Loren Moran noted recently, this alone could trigger a less responsive US Federal Reserve (Fed) sooner than the market anticipates:
I think the market is far too complacent and playing by an old playbook…I don’t think market participants think the Fed would sit on their hands and watch a 10% decline in stocks or a 50 bps widening in IG corporates, but I think they have no choice. In a perverse way, they almost need it to slow inflation and potentially draw retirees/others back into the labor force. And that means that we should be pricing in the risk of a much larger move.
The implications of a less responsive Fed extend far beyond fixed income. In recent weeks, equity market action has suggested the “buy-the-dip” mentality is alive and well. The week ending January 28 saw the 20th biggest divergence between intraday and close-to-close volatility in the last 40 years, according to Derivatives Strategist Gordy Lawrence. ETF investors likely played a role in this extreme intraday market action. As CNBC reported recently, the SPDR S&P 500 ETF saw four to five times its daily average volumes during that same week.
Again, to paraphrase Loren, equity investors are likely “playing by an old playbook.” “Faith-in-the-Fed” has undergirded dip buying throughout the quantitative easing era — the belief that any threat to equity market stability will trigger a Fed reaction, which will inflate risk assets. A less responsive Fed will eventually compromise that faith, especially among retail investors, a cohort whose confidence has no doubt already been shaken by significant underperformance during the growth to value rotation (Figure 2).
To be clear, this is neither a bullish nor a bearish note. As Gordy has written about equities: “Historically, on average, environments like our current one have tended to be followed by positive returns.” And as Fixed Income Portfolio Manager Rob Burn noted about the historical performance of US corporate high-yield bonds heading into Fed tightening cycles: “Spreads not only tightened leading up to the first hike, but also generally continued to modestly tighten after the first hike.”
Nonetheless, with seismic macro questions looming over markets, liquidity appears likely to continue to tighten and volatility to rise. To quote Gordy:
With a long list of sources of macro uncertainty to cite, we find it easy to believe that trading conviction is extremely low and prone to reversals of view, even within the same day. When liquidity contracts, every trade is more impactful, so with trading sentiment shifting rapidly, increased frequency and magnitude of intraday price swings is a natural result.
In the midst of regime change, the key to outperformance is likely less about predictive conclusions and more about asking the right questions. Which models, assumptions, and shortcuts adopted during the post-GFC status quo must be reevaluated now? What assets will benefit if regime change forces risk premia higher and investors to seek new avenues for diversification? How do investors confront their fears and biases while maintaining conviction in their conclusions rooted in fundamentals? Analyst Eunhak Bae recently shared a mantra of a past mentor, which bears repeating: “True risk is inversely correlated to perceived risk.”
Building climate resilience: Toward a practical corporate frameworkContinue reading
Can US bank loans “carry” investors through 2023?Continue reading
Multi-Asset Outlook — A rocky road to recovery in 2023Continue reading
Annual message from our CEO: Forward thinkingContinue reading
What’s next for infrastructure?Continue reading
2023 Investment OutlookContinue reading
Credit market outlook: Partly sunny with a chance of good valueContinue reading
Building climate resilience: Toward a practical corporate framework
The need for systemic climate change resilience is becoming clear. We present a practical framework to help companies enhance resilience in their own operations.
Can US bank loans “carry” investors through 2023?
Fixed Income Portfolios managers Jeffrey Heuer, CFA and David Marshak and Investment Director Nick Leichtman describe what they see as the most prudent approach to the bank loans asset class in 2023 and why.
The role of ESG in fintech
Global Industry Analyst Matt Ross and Portfolio Manager Matt Lipton explore the role of ESG in fintech in this clip from their WellSaid podcast episode.
Multi-Asset Outlook — A rocky road to recovery in 2023
Markets may be jumping the gun when it comes to expectations for a policy pivot and the likely risk-asset rewards. Members of our Investment Strategy team still see bumps in the economic road, though their outlook has brightened a bit when it comes to China and other emerging markets.
Could Japan face a UK-style pension crisis?
Investment Director Masahiko Loo explores the risks of Japan facing a UK-style pension crisis and identifies fundamental reasons that make Japanese pension funds inherently less vulnerable.
Annual message from our CEO: Forward thinking
After a year of profound economic and market change, CEO Jean Hynes discusses the path forward, including the role of alternatives and sustainability, the firm's investments in talent, and the importance of stability and innovation.
What’s next for infrastructure?
Portfolio Manager Tom Levering and Global Industry Analyst Tim Casaletto explore the outlook for infrastructure assets in 2023 across each of the key areas.
2023 Investment Outlook
As you consider your investment strategy for 2023, our Outlook collection provides you with unique perspectives across the macro environment and all major capital markets, drawing on our global marketplace of ideas more than 800 investors strong.
2023 Investment Strategy Outlook
To help think through the asset allocation outlook and implications for 2023, we offer views from iStrat, our investment strategy and solutions group.
Credit market outlook: Partly sunny with a chance of good value
In his 2023 credit market outlook, Fixed Income Portfolio Manager Rob Burn highlights some potentially attractive opportunities in the wake of this year's market sell-off.