For most of their careers, asset allocators have invested in a negative stock-bond correlation world. When stocks fall, sovereign bonds rising generally rise in value – providing a hedge against equities within a diversified portfolio. However, stock and bond prices have recently moved in tandem, as slower growth and interest rate hikes serve as headwinds for both asset classes. In this webinar, Noah Weisberger and Bruce Phelps of PGIM Institutional Advisory & Solutions examined the historical pattern of stock-bond correlation across the globe and investigated various actions that asset allocators could take to mitigate risk from a shift in stock-bond correlation. The following are highlights from the discussion.
- Exploring the history of the stock-bond relationship: PGIM IAS’ research highlights that negative correlation between stocks and bonds is not necessarily the norm. In fact, there have been persistent multi-year periods of positive stock-bond correlation. For example, investors saw around 35 years of positive correlation from the mid-1960s until 2000. This correlation pattern seems to have returned in late 2021 with equities beginning their descent into a bear market and bonds continuing to sell off as well. As new IAS research shows, changes in stock-bond correlation in other developed markets (DMs) have tended to track changes in the U.S. correlation.
- Relative influence of local and global factors: Stock-bond correlation can be explained, in part, by local policy and macroeconomic drivers. However, given the similarities between correlations in the U.S. and other DMs, it becomes clear that there is a global story as well. IAS found that a single global factor can explain about two-thirds of country-specific stock returns, with bond returns similarly global. So, for CIOs thinking about the likely path of stock-bond correlation, keep in mind that macro forces at play are not all local and not all global, but a mix of both. Therefore, an increased risk of positive stock-bond correlation in the U.S., driven by domestic fiscal and monetary policy, would simultaneously increase the risk of positive stock-bond correlation in other DMs.
- Considering alternative hedges: When stocks and bonds move in tandem, neither U.S. bonds nor other DM bonds have served as a reliable hedge for U.S. stocks. Unfortunately, there are no clear hedging alternatives. Some evidence suggests commodities have a negative correlation with stocks, on average; for instance, oil and gas, as well as gold, have typically moved in the opposite direction to equities when US bonds have not been a hedge for equities. But this relationship has only been true a little more than 50% of the time. Asset allocators must also consider that commodities exhibit greater volatility than bonds, making them a less reliable way to dampen overall portfolio volatility.
- Planning for the future: A shift from positive to negative stock-bond correlation would change the investing landscape. What can asset allocators do to mitigate risk in a world of higher volatility? As detailed in a forthcoming research paper, taking an agnostic approach – in other words, assuming zero correlation between stocks and bonds – may be a prudent path as the future reveals itself.