Stock markets

At the heart of the principle of ‘balanced’ management is the presumption of a negative – or at worst low – correlation between equities and bonds, particularly at times of large falls in equity prices. Though we have now experienced a reversal in equities, is it still too soon to draw any inferences about whether the old presumption holds or whether Quantitative Easing has changed the relationship. We think it has.
The concept of diversification between equities and bonds to smooth portfolio returns is an international one; balanced or mixed portfolios are universally the core of the investment industry’s risk control methods. This bout of equity selling started in the US and the US Treasury market is the world’s largest, widely held by foreign investors, so the US is a good place to check whether balanced management is doing its stuff so far.
The immediate trigger for the S&P sell-off was a bullish jobs report. But this came after a period of weakness in bond prices caused by the same concerns that the US economy was too strong to warrant an accommodating monetary policy. 10-Yr US Treasury yields briefly dropped to 2.1% in September before starting a barely-interrupted creep up to 2.8% just before the jobs report. Whereas both asset classes were being undermined by the same narrative, once equities started to fall that story did not prevent an instinctive and conventional ‘flight to safety’ from stocks to bonds. But only within the first day. Since then the direction has been the same for both stock and bond prices: down. It is the duration of the actual bonds held, which could be much longer than the 10-year benchmark, that will largely determine whether bonds have provided any meaningful cushion by dropping less than equities.
Though this cannot yet be considered evidence of a cyclical, let alone secular, failure of the correlation presumption behind balanced management, it is at least consistent with it. And so is the rise in the stock/bond correlation that has been going on in the US since 2014, from a low point of -0.75 to the narrow band of 0.10 to 0.20 that has held for the last two years.
If there is a ‘new’ relationship between bonds and equities it is likely to be explained by two different but coincidental factors: the unwinding of Quantitative Easing (QE) and the growth of Liability Driven Investing (LDI). QE is what has interfered with the correlations and LDI is what offers an immediately-available alternative risk-control method.
In the QE-based view, the future of both sets of returns is likely to be determined by some kind of normalisation process that does not necessarily depend on any significant change in inflation expectations, just as low or negative real yields during QE have not reflected the market’s collective inflation view. This will undermine investors’ expectations of the diversification benefits of bonds. In the LDI-based view, the suitability of nominal bonds as a hedge for an investor’s natural liabilities or objectives will be called into question, being replaced either by inflation-linked bonds or rolling over floating-rate cash equivalents. Both are more reliable ways of taking inflation bets and equity bets off the table than substituting equity risk with bond risk.
Though LDI has its own momentum, we expect to see QE normalisation acting as an accelerator, hastening the demise of the convention of balanced management. The popular US rules of thumb based on crude stock/bond blends (think ’60:40′ or ‘hold the same percentage in bonds as your age’) will soon look outdated, irrelevant, dangerous even.