The stock-bond correlation
Stock-bond correlation in developed markets
Stocks and bonds have traditionally formed the core of a balanced portfolio. A balanced 60/40 portfolio (a combination of 60% equities and 40% long-term government bonds) has often been used as a benchmark for asset allocation.
Chart 1 shows the correlation between US stocks and bonds between 1800 and 2021. For most of this period, there was a positive correlation between the two assets. However, since the beginning of this century, this correlation has decreased dramatically, and has even turned negative (while the long-term correlation between stocks and bonds has recently shown signs of rising again, it remains negative.
Stock-bond correlation drivers
Inflation is the chief driver of the stock-bond correlation. As Chart 2 shows, the stock-bond correlation is positively correlated to inflation regimes. The higher the inflation rate, the higher the average correlation between stocks and bonds. This link holds true over the long and short term alike.
The second driver of stock-bond correlations that we have identified is real rates. The higher real rates are, the more positive the stock-bond correlation, with rising rates typically seen as having a negative impact on stocks and bonds alike. Chart 3 depicts the long-term and the short-term link.
Downside risk protection in a balanced portfolio
Government bonds have historically been the best instrument for mitigating equity risk. Government bonds typically carry no default risk, exhibit low volatility and have a low correlation to equities. These characteristics mean they serve as a safe haven when higher-risk assets suffer. However, government bonds may lose this role when inflation is high and during periods of market stress when there is no room for interest rates to go lower to cushion against the decline of equities.
Combining stocks and bonds in a portfolio can be expected to lower overall portfolio volatility, with the fixed-income element acting as a shock absorber for downturns in the equity market. The protection bonds offer is strongest when the correlation between stocks and bonds is negative. Chart 4 compares the 10-year rolling volatility of a 60/40 portfolio (rebalanced at the end of each month) and the 10-year rolling stock-bond correlations in the period 1950-2021.
Developed-market government bonds have consistently protected balanced portfolios during equity market sell-offs. Since the beginning of the century, S&P 500 have experienced corrections of greater than 5% on 12 occasions. In 11 of these, US 10-year Treasuries delivered positive returns. During these corrections, the S&P 500 index declined on average by approximately 16% whereas US 10-year Treasuries generated an average return of about 8% (in US dollars).
However, the ability of government bonds to hedge equity risk is reduced when interest rates are low. When markets crashed in March 2020 as the coronavirus spread, government bond returns were negative in markets where interest rates were already below zero, as was the case in Europe and Japan. By contrast, because nominal interest rates in the US were still above zero, US Treasuries appreciated by 7.6% between late February and late March 2020, a period when the S&P 500 fell by 34%. However, compared to previous crises, low rates throughout the developed world mean the protection offered by government bonds has decreased significantly (see table 1).
Over the next 10 years, we expect the 10-year US Treasury nominal yield to increase to 3.8% from about 2.3% in early 2022, while we expect US headline inflation to decline to an annual 2.8% from 7.9%. Based on these expectations, our empirical analysis suggests that the 10-year stock-bond correlation should be slightly positive. This implies that US government bonds could still provide diversification benefits but offer lower returns than in the past. We expect 10-year US Treasuries to deliver an average annual return of 1.7% over the next 10 years against a realised return of approximately 1.9% over the past 10 years. Yet the increase in interest rates we anticipate means that the Fed could progressively have more ammunition to reduce policy rates in the case of a future financial crisis. Investors that allocated funds to government bonds prior to such a crisis would benefit from moves to cut interest rates and have a buffer against equity market drawdowns.
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The stock-Bond correlation
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