The End of an Era

by Richard Phillips, Chief Investment Officer
and Kevin Muir, CFA, Market Strategist


Executive Summary

  • For the first time in three decades, both stocks and bonds are threatening to post negative returns in 2018.
  • Negative returns for both asset classes point to a potential breakdown in the traditionally accepted principle of a negative correlation between stocks and bonds.
  • A look at a longer period of history shows that in fact the correlation between stocks and bonds has more often been positive.
  • The potential change back to positive correlation for the foreseeable future presents dangers and opportunities for investors.

 

Today, if the US and Canadian markets were to close the year where they are currently trading, it would mark a very unusual development. In the past three decades, there has never been an instance when both stocks and bonds have had negative return years. Yet here we are with the U.S. stock market hovering around zero while bonds are showing a negative return of almost 200 basis points.

 

And it’s worse for other countries. For example, here in Canada, our stock market is down almost 4% while the bond market is approximately unchanged.

Most investors who are saving today have been blessed to have lived through a period in history when stocks and bonds have been negatively correlated. Negative correlation means that when stocks have gone down, bonds have done the opposite and rallied.

To illustrate this relationship, here is the chart of the S&P 500 along with the Bloomberg Barclays Government Bond Index. The 180-day correlation is in the bottom panel.

A zero correlation reading implies that there is no relationship between stock and bond return for the period in question, whereas a positive reading means that the two assets were moving together in the same direction. But if you look closely, you will notice that for the vast majority of the last two decades, stocks and bonds have been decidedly negatively correlated.

In Canada the correlation is not quite as entrenched, but there is also a strong enough relationship to declare stocks and bonds negatively correlated. Here is the chart of the TSX Composite Index with the S&P Canada Government Bond Index, along with the 180-day correlation.

Observe when the negative correlation reaches its strongest readings. It is more often than not during periods of stock bear markets.

It’s easy to understand why investors have assumed that stocks and bonds are, on the whole, negatively correlated – especially when it matters – when stocks are under stress.

Although this negative correlation might not seem like a big deal, the implications from this relationship have been enormous.

The Effects of the Negative Correlation

When combined with the fact that bonds have been in an almost four-decade-long bull market, negative correlation had enabled investors to take more risk with their portfolio construction than would otherwise be prudent. For example, if a portfolio manager were confident this negative correlation would continue, and that bonds would also provide a positive return over the long-term, then allocating a large portion of the portfolio to equities, with an offsetting large bond position would create a mix that would be able to withstand larger draw-downs. It would in essence be the best of both worlds. The portfolio could be more highly weighted to equities because the manager would be confident that in times of trouble, the other half of the portfolio – bonds – would provide a positive cushion.

The problem with today’s market is that this logic has been applied by millions of investors throughout the globe. It is easy to understand why. It has been a terrific trade and been so effective that it spawned an entire new type of portfolio management called risk parity. This strategy takes the idea one step further and concludes that given the negative correlation, and the fact that bonds have traditionally been less volatile than stocks, it makes sense to use leverage and buy an extra portion of bonds so that the risk for stocks and bonds are equal. Given the 37-year bull market in bonds, allocating leverage to the bond portion along with a sizable stock position has been an intelligent and rewarding move.

Although the negative correlation between stocks and bonds has been dependable for the past few decades, it has occurred during a period of declining rates of inflation. This decades-long phenomenon has resulted in interest rates which have declined in sympathy.  Many investors have been fortunate enough to ride the wave of the greatest secular bond bull market in the history of finance.

However, the Great Financial Crisis of 2008 introduced a challenge to many investors’ plans. Through aggressive rate cutting and unprecedented quantitative easing by the world’s Central Banks, bonds throughout the globe were pushed to interest rate levels that offered little return.

This wholesale lowering of the risk-free rate had two profound effects. One, it forced investors out both the risk curve (instead of buying AAA sovereign bonds investors would purchase BBB bonds or something more risky) and the yield curve (instead of buying 2 or 5-year paper, investors bought 10 or 30-year bonds in an attempt to get the same yield). Two, by lowering the risk-free rate so extensively, governments increased the present value of all financial assets. In essence, everything became expensive. Whether it be bonds, stocks, real estate or private equity – when the risk free rate was lowered so dramatically, it pushed up the present value of all assets.

Creating a portfolio today has become dramatically more difficult than at anytime in the past few decades. Most risk asset markets are fully priced, and even more importantly, the diversifying benefit that usually accompanies mixing equities with bonds may be fading.

The End of an Era

We believe that investing based on the premise that this traditional inverse correlation between stocks and bonds will continue is potentially a dangerous mistake.

For the past few decades, this inverse correlation has largely been the result of Central Banks’ reaction function to financial market disruptions. As the world’s economy has become more “financialized” it has become more sensitive to market events.  During each successive crisis, Central Banks have had to stimulate with progressively larger amounts of monetary firepower. In 1987 when the stock market crashed, Alan Greenspan had to cut rates by 75 basis points to stabilize stocks. Contrast that to 2008 when Bernanke cut rates from 500 basis points to zero and had to augment it with quantitative easing to finally arrest the dangerous self-reinforcing credit destruction cycle.  This need for more and more monetary stimulus has been the result of the ever growing amount of debt perched precariously on an unstable financial footing.

But for a whole host of reasons, the disinflationary trends that have allowed Central Banks to apply aggressive amounts of monetary stimulus without causing traditional inflation are ebbing (see Too Late to Stop Now: The Case Against Bonds).

If global financial markets were to transition from a world with a disinflationary tendency to one with an inflationary bias, the negative correlation relationship between stocks and bonds might shift to a positive correlation.

Although for most investors it seems intuitive that stocks and bonds should be negatively correlated, this is by no means a given.

We have taken the liberty of reproducing a wonderful chart from a piece by Artemis Capital’s Christopher Cole: Volatility and the Alchemy of Risk;

This chart shows that over the past century and a half stocks and bonds have more often than not been positively correlated – not the other way round.

Here is another chart from Jack Fan and Marci Mitchell – Equity-Bond Correlation: A Historical Perspective:

Again this chart demonstrates that the relative returns between stocks and bonds are by no means a constant relationship.

How Does an Investor Prepare for this Possibility?

The fixed-income portion of an investor’s traditional balanced portfolio has two glaring problems.  Central Banks have repressed yields to levels that offer a poor risk reward profile. But even more importantly, one of the main reasons for including bonds in a portfolio, namely their negative correlation to risk assets, is not guaranteed. We believe this year’s example of both financial asset classes declining together is not a one-off. Investors should be bracing themselves for the possibility of more years like this one.

Investors are facing a difficult environment. Risk assets appear rich. Traditional fixed-income products’ interest rates are low. Combine that with the possibility the negative correlation between the two asset classes has ended, and you have the makings of a near impossible situation for portfolio construction.

At East West we believe that accredited investors who invest in a diversified portfolio of alternative yield funds will outperform traditional portfolios. These alternative funds offer non-correlated returns while still providing high single digit to low teen current yields. Many of the available funds hold low duration assets, so in an inflationary environment, yields should be able to rise with rates.

With the low levels of interest offered by traditional fixed-income securities, investors are hardly hoping for a high total return.  Yet the truly disturbing part of the current environment is the possibility that not only do these traditional fixed-income securities offer little real return, there is a real chance that the rug is pulled out. Instead of providing safety they may further drag down a traditional portfolio if the correlation between stocks and bonds reverts to a positive one.

Although we acknowledge that taking advantage of the negative correlation between stocks and bonds has been a consistent and lucrative strategy over the past couple of decades, we are concerned that this relationship may be ending. If so, traditional portfolios will struggle. We believe a portfolio with alternative yield funds is a much better solution.