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Thursday, 3 May 2018

New correlations spell concern for bond and equity investors (FT)

"Simultaneous drop in debt and stock prices marks an uncomfortable break with recent trend.

Investors are starting to see a pattern in the bond-equity relationship that could have profound and worrying implications for their portfolios.

The rare combination of equity and bond prices falling at the same time has become more frequent of late. Since 2000 there have only been 57 trading days where the S&P 500 lost 0.5 per cent or more and the 30-year US Treasury bond yield also rose 3 basis points or more, according to Morgan Stanley. But there were a handful of such days in just the last month. 

While US stocks have regained their footing in April and inflation data out on Monday calmed the bond market, both the S&P 500 and Bloomberg Barclays Aggregate, a popular bond index, lost more than 1 per cent in the first quarter — only the fourth time this has occurred in the past three decades. 

This could have significant implications for a lot of investors that depend on bonds and stocks to counteract each other, warns Larry Hatheway, chief economist and head of investment solutions at Gam, an asset manager: “Bonds and equities falling at the same time is the portfolio wrecker.” 

Both bonds and equities have done well over the past three decades, a period characterised by moderating inflation. Crucially, during bouts of turmoil a swoon for stocks usually results in high-quality bonds performing well, acting as an important stabiliser for portfolios.

Now as some investors anticipate a more inflationary environment, there is anxiety that the yin and yang of financial markets — two opposing but complementary asset classes — is fraying. 

Accelerating inflation eats directly into fixed income returns and indirectly threatens the bond market by spurring central banks to raise interest rates more aggressively. 

While rising inflation expectations are caused by stronger economic growth, which should be good for equities, that calculation is now in practice far knottier. Rising yields harm companies by lifting borrowing costs, and make their stocks look relatively less attractive compared with owning safer securities. They also risk damping debt-financed share buybacks, while wage pressures crimp profit margins. 

UBS Asset Management has mapped out four broad “correlation regimes” over the past century. The rolling five-year correlations of the S&P 500 and 10-year Treasury yields were positive from 1970 to 1998, but have been almost entirely negative since the late 1990s.

Erin Browne, head of asset allocation at UBS Asset Management, argues that while the correlation will probably be pushed closer to positive territory in the coming years, she doubts that the inflationary pressures are strong enough to restore the close relationship seen in the era of “stagflation”. 

Still, the rise in correlations is already beginning to weigh on some popular investment strategies. The volatility of a typical “balanced” portfolio made up of 60 per cent global equities and 40 per cent bonds has picked up lately as both bonds and equities have become more sensitive to any data points that indicate inflation could pick up, analysts at HSBC note. 

There are still widespread doubts among bond investors that inflation is accelerating meaningfully. Indeed, while data published on Monday showed the Federal Reserve’s preferred measure of inflation jumping from 1.6 per cent in February to 1.9 per cent in March, the move was largely driven by base effects and widely foreseen by economists. As a result, bonds were unmoved. 

Gene Frieda, a strategist at Pimco, does not foresee inflation becoming a real problem but worries that rising bond-equity correlations could prove particularly problematic for balanced portfolios that use leverage to boost the returns of fixed income — such as a strategy known as “risk parity”. 

Risk parity funds invest in a variety of markets according to their mathematical volatility, using leverage to ensure that all asset classes contribute equally and to enhance returns. In practice, that usually means leveraging up the fixed income investments, but this has long worried some analysts, who fret that risk parity funds forced to deleverage their bond investments could worsen the headwinds.

“Correlations can be positive for short periods of time, but if bonds sell off in a big equity downdraft it is a big problem,” Mr Frieda said. “The question is more the ecosystem, the financial architecture. Is there a strategy that is large enough [when correlations rise] that it could cause systemic ripples . . . Risk parity is part of it.” 

Risk parity funds also invest in commodities and other inflation-linked securities, which should help offset fixed income losses in an inflationary environment. But a risk parity index that gained 230 per cent in the two decades to 2018 — comfortably beating the S&P 500 and with considerably less volatility — has dipped 2.3 per cent so far this year. 

Given that low bond yields will regardless crimp the protection they offer, and the muddled outlook for commodity prices, Morgan Stanley’s Andrew Sheets argues investors should explore other cheap diversifiers — such as bets on more volatility. Nonetheless, if the two biggest corners of the global financial markets suffer a unison reversal then the damage could be severe. 

“Correlation risk is a biggie,” said Tom Clarke, a portfolio manager at William Blair. “Correlations moving around can do a lot more damage than volatility rising.”"


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