Global fixed income markets tend to move in lock-step with the asset class unlikely to offer much of a hedge should US stock and bond markets flip to positive correlation, according to a new study by investment giant, PGIM.
The PGIM analysis found all developed market (DM) bonds closely follow US stock correlation trends, suggesting investors will find little respite should the asset classes converge – a circumstance last recorded 20 years ago.
“Indeed, 94% of the time the US stock-bond correlation regime (positive or negative) is matched by the US stock-DM (hedged USD) bond correlation regimes… In short, when US bonds are not a good hedge for US stocks, neither are DM bonds,” the study says.
The paper – authored by PGIM institutional and advisory solutions managing director, Noah Weisberger, and senior associate, Xiang Xu – says chief investment officers (CIOs) and asset-allocators will need to watch both US and local economic and monetary policy trends for indications of correlation changes between stock and bond markets.
“A shift to a positive stock-bond correlation regime will likely be widespread across developed markets, with the loss of sovereign fixed income as a strong equity hedge in a multi-asset portfolio,” the report says.
“… For CIOs, the broadest takeaway is that debates about the stance of fiscal and monetary policy are neither theoretical nor esoteric. Policy settings influence key economic aggregates, which in turn are directly relevant for stock-bond correlation,” the PGIM paper says. “Secondarily, there is a balance between global and local forces. For those who tend to focus exclusively on US risks, local dynamics ought to be considered too; and for those who focus on domestic determinants of local market dynamics, common global factors also need to be assessed.”
Despite some uncorrelated economic features, emerging market (EM) bonds also remain a poor hedge against US share losses, the study found.
“Given the limited history of EM bond returns, and the fact that US stock-bond correlation was last positive prior to 2000 (in fact, we dropped China from this analysis because of data limitations), there is little evidence for how EM (hedged USD) bond returns have behaved relative to US stock returns when US stock-bond correlation was positive,” the report says. “That said, EM (hedged USD) bond returns have generally been positively correlated with US stock returns, even when US stock-bond correlation was negative. There is little to suggest that EM bonds would be a better hedge for US stocks when US bonds are not.”
If US stocks and bonds do move into positive correlation, investors might find some refuge in commodities, PGIM says, but any slight advantage gained also comes with higher risks.
“Oil, Gold and Energy total returns are negatively correlated with US stock returns. However, even in these cases, negative correlations are quite modest in magnitude…,” the PGIM study says.
“… the odds of US stock and commodity returns being negatively correlated, conditional on positive US stock-bond correlation, are only slightly better than 50-50, with a high of 63% for GSCI crude oil total returns. Moreover, any hedging benefit comes at the cost of much higher volatility, ranging from 19% to 36%…”