For the past two decades the correlation between stock and bond returns has been negative, meaning that when stocks have performed poorly, bonds have tended to do well, and vice versa. Stock-bond correlation plays an important role in institutional portfolio construction, and a negative correlation means that stock and bond returns tend to hedge each other, dampening the overall level of portfolio risk for a given allocation to stocks.
PGIM’s Institutional Advisory & Solutions (IAS) group recently published a research paper examining US stock-bond correlation and its macroeconomic drivers. To discuss this research and its possible portfolio implications, we brought together PGIM experts to provide insights on what a change in correlation regime might mean for investors’ asset allocation decisions. The following are brief highlights from the webinar.
- Negative stock-bond correlation isn’t permanent: While stock-bond correlation has been persistently negative since 2000, the correlation was persistently positive from the late 1960s until the late 1990s, after having been negative in the decade-and-a-half before that. Sustainable fiscal deficits, independent and rules-based monetary policy, and demand-side shifts tend to support a negative correlation, while unsustainable fiscal policy, discretionary monetary policy, monetary-fiscal policy coordination, and supply shifts tend to support a positive correlation.
- Implications of a shift in correlation: A shift from negative to positive stock-bond correlation would mean that stocks and bonds no longer tend to hedge each other. Assuming unchanged expected returns and volatilities for stocks and bonds, the loss of this hedge would lead to an increase in the volatility and value-at-risk of a balanced portfolio and a decrease in the portfolio’s risk-reward profile. Alternatively, maintaining current risk levels in the face of a shift to positive correlation would require a reduction in the allocation to stocks and expected portfolio performance.
- Correlation among other assets: Investors should also be aware of the historical correlation between assets aside from bonds - relative to equities - to consider as other possible hedging assets. For example, during the period from 1985 to 1995, commodities and gold both exhibited negative correlation to equities at a time when stock and bond correlations were positive.
- What lies ahead?: Anticipating changes in correlation requires understanding the interaction between policymaking and economic data. Although the current negative stock-bond correlation regime has coincided with persistently falling and low interest rates, continued low interest rates alone are not enough to support a negative correlation. Investors should focus on the broader policy backdrop. With both fiscal and monetary policy changing from their past patterns, CIOs must remain open-minded to potential shifts in stock-bond correlation. For CIOs with strong macroeconomic views, our research can help translate those views into an expectation for the correlation and optimal portfolio construction. For CIOs without strong views, assuming a zero correlation would likely produce a more prudent risk assessment.
PGIM’s IAS team conducts bespoke, quantitative client research that focuses on strategic asset allocation, and portfolio and asset class analysis across both public and private markets. To access additional research and thought leadership from IAS, click here.