EQUITIES AND BONDS – WHAT’S GOING ON WITH THEIR CORRELATION RELATIONSHIP?

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For years, the relationship between the price movements of equities and bonds has been a well-known cornerstone of investing: when one asset class moves up, the other dependably moves down – otherwise known as a negative correlation. While not always a sure bet, of course, it’s been seen as a reliable rule of thumb that has helped investors devise “balanced” portfolios (one with set percentages of equities and bonds) that could realise strong returns when equity markets are up, yet provide a measure of protection when equities are out of favour.

The correlation relationship is one of the core foundations of diversified, multi-asset investing. The rationale behind this is the perception of bonds as lower-risk, higherquality investments which, while not as exciting as equities, can offer dependable yield (hence the expressions “flight to quality” or “flight to safety” when traders sell out of equity positions and buy bonds).

In 2018, however, something fairly unusual happened: both equities and bonds were down in the same year. While it’s not uncommon for both assets to provide positive returns in a given year, a negative year for equities and bonds was definitely noteworthy, and has had investors asking what this might mean for asset allocation going forward.

There are numerous theories as to why 2018 was a bad year for both equities and bonds. Geopolitical developments (particularly the U.S./China trade war), slowing global economic growth, and the spectre of rising inflation made conditions less than ideal. Divergent central bank policy provided mixed signals: while the U.S. Federal Reserve was raising interest rates in hopes of slowing the pace of growth in America, central banks in the U.K., Europe and elsewhere were struggling to spark their economies. And as the effects of a massive corporate tax cut in the U.S. initially boosted equities in the early months of 2018 but then faded, supplies of Treasuries (U.S. government bonds) increased significantly to cover the costs of the tax cut, putting pressure on bond prices as well.

By the end of May 2019, equities and bonds appeared to resume their traditional negative correlation. Equities retreated as bond yields fell (meaning bond prices increased), as investors looked for safe havens from higher-risk assets amid a deterioration in the U.S./China trade relationship, which has a significant knock-on effect for the global economy. Does this imply a reversion to the mean? Not necessarily – through early August, both asset classes were positively correlated again, with equities and bonds rallying.

What this does tell us is that diverse asset classes rarely have identical performance from year to year, and the relationship among them is not always in lock-step. If anything, it reminds us of the importance of a long-term investment outlook, an approach that is prepared to weather any short-term storms. It also underscores the benefits of portfolio diversification. Whether correlation between any two asset classes is positive or negative can change depending on the prevailing investment conditions. 

DIVERGENT CENTRAL BANK POLICY PROVIDED MIXED SIGNALS: WHILE THE U.S. FEDERAL RESERVE WAS RAISING INTEREST RATES, CENTRAL BANKS IN THE U.K., EUROPE AND ELSEWHERE WERE STRUGGLING TO SPARK THEIR ECONOMIES.

Diversification provides not only a degree of protection when one asset is down, but allows investors to capture growth opportunities when another asset is in the ascendant. The traditional balanced approach to investing is still the most time-tested way to grow and protect wealth into retirement. And portfolios that offer even more diversification can potentially realise better returns when equities are in a bear market.

With that in mind, what steps can investors take to improve the resilience of their portfolios? Within a traditional balanced portfolio, a more defensively positioned mix of different types of equities and bonds could be less affected by an economic downturn. Another option would be to pursue a more wide-ranging asset mix.

For example, when Scottish Widows launched the Premier Portfolios range, we took the decision to increase the flexibility around what types of assets to invest in, with the aim of having greater scope to navigate changing market dynamics. We included defensive tilts within our growth-seeking assets such as high-yield bonds, absolute return and low-volatility smartbeta strategies; real assets such as property and commodities, as well as currency hedges on a portion of our equities. We also make use of a tactical asset allocation overlay, which allows us to take account of relative value opportunities in specific asset classes or markets in the shorter term.

It’s worth noting that in 2018 – a year in which both equities and bonds posted negative returns – the Premier Portfolios outperformed their default portfolio counterparts, which hold only equity and bond funds. If last year has taught us anything, it’s that asset classes can sometimes move in unexpected directions and flip the script on established rules – reiterating the importance of a long-term, diversified investment viewpoint.

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