Regime change likely to challenge modern market structures

The potential breakdown of the negative stock/bond correlation exemplifies why

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:

Figure 1

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 20^th 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).

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:

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.”