In October, the 10-year U.S. Treasury yield hit a 7-year high in response to strong economic news, contributing to the second major equity sell-off this year.1 If positive moves in yield continue to drive down equities, this would mean an end to the hedge between stocks and bonds that has been in effect since around 2002. Investors may seek alternative means of diversification, with potentially deep ramifications for strategic asset allocation decisions and multi-asset class strategies.
TRACKING CORRELATION TRENDS
We’ve seen this dynamic before. In fact, Andy Sparks, MSCI’s Head of Portfolio Management Research, recently called “the notion that fixed income offers a refuge from stormy equity markets is a ‘slippery concept,’ given the number of times the correlation has flipped over the years.”2
When measured over a short period, the correlation has shifted considerably in recent years. Throughout the “taper tantrum” of 2013, good news for the economy was bad news for the markets (both stocks and bonds), and the correlation weakened substantially. This year, the correlation has again moderated to a similar extent. On the other hand, when measured over a longer period – as is done in the MSCI Multi-Asset Class Factor Model – the correlation has been reliably negative. Nevertheless, even the long-term trend has been softening. Short-term estimates are more responsive, and may serve as early warning signs for a regime shift.
Short- and long-term correlations between equities and US Treasurys
Source: Treasury returns are from the ICE BofAML US Treasury Index (G0Q0), used with permission. Equity returns are from the MSCI USA Index. We used an exponentially weighted moving average (EWMA) correlation estimate with a half-life of six months for the responsive (short-term) view, and with a half-life of three years for the stable (long-term) view. The latter estimate is comparable to the MSCI Multi-Asset Class Factor Model (long model).
IMPLICATIONS FOR 60/40 ALLOCATIONS
Managing the risk of a structural change in the bond-equity correlation involves analysis of historical data but also judgment. And there are reasons for concern. The rise of populist, protectionist governments bring the threat of de-globalization, slowing growth and increasing budget deficits. This, in turn, could lead to an inflation shock, which could have a negative impact on bonds and (real) equity prices, driving the correlation positive. As we wrote in June, a positive correlation together with increased interest-rate volatility could harm long-term investors with traditional 60/40 allocations.
While one or two sell-offs do not constitute a trend, interconnected risks – increased rate uncertainty and the potential disappearance of the bond-equity hedge – may be an important medium-term scenario to manage against. In such a scenario, long-term investors would likely be under significant pressure to find alternative sources of diversification.
1 For example, see Wigglesworth, R. “What is behind the global stock market sell-off?” Financial Times, Oct. 11, 2018, and Kinahan, J.J. “Equities under pressure as government debt selloff pushes up global yields.” Forbes, Oct. 4 2018.
2 Kilburn, F. “Tenets of investment, upended.” Risk.net, Oct. 30, 2018.
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