Equities and bonds are likely to move in the same direction in the near-term bar an economic ‘hard landing’, according to a Mercer study, but diverge again over time if monetary conditions normalise.
Following the 2022 shock that saw both shares and bonds slump in tandem to produce the worst combined losses “dating back to 1872”, the two anchor asset classes have remained in positive correlation mode – calling into question long-held portfolio diversification assumptions.
“… although markets have recovered from the sell-off, the correlation between equities and bonds has remained elevated, as the key determinant of central bank policy shifted from managing the business cycle (i.e. unemployment and growth) to inflation,” the paper says.
But in the Mercer base case of a ‘soft landing’, where inflation and rates ease without a recession, bonds and shares would remain in lock-step on the upside.
Conversely, in a ‘no landing’ scenario of strong growth and higher inflation (and possibly rising rates), both assets classes would fall in tandem, the report suggests.
If the global economy spirals down to a ‘hard landing’ of declining growth and high inflation, though, the bond-equities negative correlation should reappear “akin to what was generally the case over the past few decades”.
“However, the critical question is whether central banks in each scenario now have more room to cut interest rates, if need be, to backstop the economy, and thereby investors’ portfolios, as we are primarily concerned with volatility on the downside,” the Mercer paper says.
“… After all, no one complains when equities and bonds simultaneously increase in value, only the opposite is really an issue for investor portfolios.”
Written by Mercer US multi-asset associate, Max Becker, the study suggests real yields act as the underlying driver of the bond-shares correlation over the long-term while risk appetite determines shorter-term return relationships.
Comparing monthly returns of the two asset classes over five-year rolling periods dating back to 1900, the Mercer analysis found that “as real yields move lower (which we saw in the 2010s), the equity/bond correlation tends to persist at more negative levels”.
“However, when real yields move higher, the subsequent rolling five year correlation tends to turn more positive.”
In fact, the data shows five-year rolling correlations between bonds and shares have been “positive more often than not” over the previous 124 years.
Becker says the portfolio implications of the changing bond-equities correlations will vary depending on investor objectives, ranging from adding more diversification to holding steady in a 60/40 balanced investment strategy.
He says “sustained positive correlations” between shares and bonds have seen many asset allocators revisit “the working assumptions they had used for many years”.
“Extending the time horizon from a tactical view to a strategic one, it has not been surprising that equity/bond correlation has moved more positive given the dramatic run up in interest rates,” Becker says. “However, in a more stable rates environment we would expect correlations to decline to more normal historic levels. But you do not need correlations to be negative to get portfolio diversification, you just need correlations to be materially lower than one.”