Overview
An encouraging sign for bondholders: the 3-month equity-bond correlation has turned negative again. Granted, we were here not that long ago - there was an inverse relationship between the two asset classes as recently as July 2023 – but how investors think about this correlation should be guided by context, and that is very different now.
The Federal Reserve has a dual mandate – stable prices (through targeting inflation) and maximum employment. While the last two years have been all about bringing inflation back to target, the focus is now shifting to growth. Growth has been slowing in the US, with the fiscal support of 2023 turning into a drag, consumers growing more cautious, and the labour market in a clear downtrend (despite what the August jobs report said).
Central banks and markets are taking note. The Fed stands ready to offer monetary policy accommodation and we heard Federal Reserve Chair Powell set the tone in his speech at Jackson Hole last month when he said: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data.”
As the focus on growth intensifies, this pushes the bond-equity correlation to more normal (negative) levels, because lower growth drives equity prices lower and drives bond yields lower. For investors, the implication of this negative correlation is that bonds are once again acting as a hedge in portfolios.
A lower correlation between bonds and equities is generally beneficial for a multi-asset portfolio, other things being equal, because it reduces the expected volatility of the portfolio as a whole. If the correlation is negative, then bonds should offset to some degree negative moves in equities.
However, in the real world other things never are equal, and we should sound a note of caution. The market is currently pricing in a more aggressive path of Fed interest rate cuts than we believe is warranted. While bonds may therefore be a better hedge against downside equity risks than they have been in the recent past, they carry their own downside risk too. Longer dated bonds look especially vulnerable to a pull-back. The term premium remains very compressed, which in the context of heavy issuance is likely to be a challenge for these bonds. While we remain constructive on the asset class over a longer-term horizon, we have recently moved tactically underweight government bonds for the above reasons.
