For most of the 21st century, stocks and bonds have exhibited a tendency to move in opposite directions - which has allowed investors to construct diversified portfolios but also to hedge out some equity risk using bonds where appropriate.
However, as this week’s Chart Room shows, in certain sectors, this correlation is starting to reverse itself and turn positive in the wake of the economic fallout and recovery from the Covid-19 pandemic. This means that when equity prices rise, bond prices are starting also to rise (and bond yields to drop). The sectors where this is most evident include technology, consumer discretionary and communication services. Stocks and bonds were negatively correlated in all these sectors over the last five years on average.
A lasting shift?
Ultra-low interest rates and prolonged easy monetary policy have buoyed stock valuations for companies perceived to have long-term earnings power. The more valuations are driven by earnings in the distant future, the more sensitive they become to changes in the discount rate, and therefore bond yields. As a result, rising bond yields (and falling bond prices) could also cause stock prices to drop. It’s no surprise that the three sectors where assets are becoming the most highly correlated have the richest cyclically-adjusted valuations.
It remains to be seen whether the current shift to positive correlation will evolve into a long-term trend. Stocks and bonds moving in tandem would mean a deteriorating ability to diversify one’s portfolio and the loss of previous hedging benefits.
Historically, stocks and bonds tend to go in the same direction during periods of heightened inflation concerns. In response to the pandemic, central banks around the world have rolled out massive monetary and fiscal stimulus programmes, and there are signs that inflationary pressure is building up. Data released this week showed consumer price inflation in the US at a 13-year high in June.
While traditional equity and bond mixes will continue to drive portfolio positioning, investors might need to find alternative ways to diversify their portfolio if such positive correlations persist. Among alternatives for consideration are gold, real estate and private assets across debt and equity. Meanwhile, equity exposures to those sectors that still have a negative correlation to bonds - predominately financials and to a lesser extent energy - can still be hedged to various degrees with bonds.