Investors relying on a negative correlation between equities and bonds could face a shock in 2016, according to a new analysis by global fixed income giant PIMCO.
The PIMCO 2016 asset allocation outlook says investors relying on the traditional stock/bond counterbalance should beware if the year ahead features stagnant growth combined with rising inflation expectations and higher yields with a hawkish Federal Reserve.
“… this would be an environment where the correlation between bond returns and stock returns could be less negative than expected, surprising investors and resulting in higher-than-expected volatility in portfolios that rely heavily on the stock-bond diversification hypothesis,” the PIMCO report says.
In fact, the PIMCO study says until the late 1990s there was a more positive correlation between equities and bonds than latter-day investors have become accustomed to.
“As inflation expectations finally became anchored in the 1990s, changes in discount rates became increasingly correlated with changes in growth, leading to the negative correlations between bonds and stocks that many investors now take for granted,” PIMCO says.
Despite such high-level concerns, the PIMCO report says “bonds will continue to play an important role in investor portfolios of diversification, income generation and loss mitigation”.
However, the study paints a difficult, if potentially-rewarding, year ahead for investors as markets shift from a period of “cheap valuations, stable correlations and low volatility” to less predictable times.
“This is an environment where strategies that were successful over the past several years may not be as attractive,” the PIMCO analysis says. “Rather, the volatility and dislocations should create compelling investment opportunities. Indeed, active management’s potential for added returns has thankfully not shrunk…”
The report, titled ‘Altitude Adjustment: Investing During a Period of Lower Returns and Higher Volatility’ was authored by Mihir Worah and Geraldine Sundstrom, PIMCO CIO asset allocation and portfolio manager asset allocation respectively.