Equities and Bonds: Friends With Benefits
The relationship between bonds and equities is a cornerstone of portfolio construction, serving as a foundational principle guiding asset allocation strategies. Traditionally, these asset classes are expected to exhibit negative correlations due to their distinct responses to economic conditions and investor sentiment.
Conventional wisdom suggests that in a strong economy, corporate earnings rise, driving equity prices higher as companies become more profitable. In such scenarios, central banks often raise interest rates to control inflation, leading to lower bond prices since bond yields move inversely to their prices. Conversely, in a weak economy, corporate earnings fall, pushing equity prices down. Simultaneously, central banks may lower interest rates to stimulate growth, resulting in higher bond prices. Therefore, when equities perform poorly, bonds typically perform well, providing a hedge against market downturns.
To illustrate the historical relationship between bonds and equities, the chart below displays the 100-day rolling correlation between the S&P 500 index and the 10-year U.S. Treasury (USTs). This chart highlights how the correlation between these two asset classes has evolved over time, showcasing periods of both negative and positive correlations.
100-day correlation of S&P500 and 10-year Bond Return (daily % change)
Source: Bloomberg, W1M. Data as at 19th August 2024.
Over the past 25 years, and particularly since 2008, the correlation between bond and equity returns has been consistently negative. This negative correlation has acted as a stabilizer in a balanced portfolio during various equity market declines.
However, while conventional models suggest a negative correlation, certain periods deviate due to various factors—most notably, inflation.
Inflation impacts both bonds and equities but in different ways. High inflation erodes real bond returns, making them less attractive, and can lead to higher interest rates, which negatively affect bond prices. For equities, moderate inflation can be beneficial as it often accompanies economic growth. However, excessive inflation can harm corporate earnings and lead to higher discount rates, negatively impacting equity valuations.
To visualize this, the scatter chart below shows the 3-year average U.S. core inflation rate versus the 3-year rolling correlation of the S&P 500 Index and the 10-year UST monthly returns. Historically, higher inflation rates have tended to result in more positive correlations between bonds and equities. This occurs because high inflation often triggers monetary tightening by central banks, leading to simultaneous declines in both bond and equity prices.
US Equity / Bond correlation and Core Inflation
Source: Bloomberg, W1M. Data as at 19th August 2024.
The black dot represents the latest observation, positioned at the extreme end of all observations since 1985, with the 3-year average core inflation at 5%, and the rolling 36-month correlation of monthly returns for Treasuries and equities at 64%. The chart suggests that when the average core inflation rate over 3 years reaches 2.5% or higher, the correlation between bond and equity returns becomes significantly positive.
A crucial consideration for investors is understanding how bond/equity correlations behave during periods of acute market stress. During such times, correlations often become more negative—just when they are most needed. This phenomenon was observed during major market downturns like the COVID-19 pandemic, the Global Financial Crisis (GFC), and the dot-com bubble burst.
For instance, during the COVID-19 crisis, as equity markets plunged due to uncertainty and economic shutdowns, USTs surged as investors sought safer assets. A similar pattern emerged during the GFC, where equities fell sharply, and USTs provided a safe haven. During the dot-com bubble burst, the tech-heavy equity market suffered substantial losses, while USTs benefited from the flight-to-safety phenomenon.
The charts below demonstrate that during significant market stress, the negative correlation between bonds and equities becomes more pronounced.
Return of Equities vs. Bonds During Recent Recessions
Source: Bloomberg, W1M. Data as at 19th August 2024.
Recent events have reinforced this pattern. During the volatility of the past few weeks—where the S&P fell by 8.7% due to a negative unemployment surprise and weak ISM survey data—the bond market exhibited a textbook response, offering further evidence that the relationship remains intact when it matters most.
Return of Equities vs. Bonds (16th July 2024 – 16th August 2024)
Source: Bloomberg, W1M. Data as at 19th August 2024.
Understanding the correlation between bonds and equities is crucial for portfolio diversification and risk management. While the traditional expectation is a negative correlation, various factors, particularly inflation, can cause deviations. However, historical evidence shows that during periods of acute market stress, bonds and equities tend to revert to a negative correlation, offering the diversification benefits necessary to protect portfolios.
These critical moments of market stress are when investors most rely on negative correlations to safeguard their investments. Conversely, during normal market conditions, when equities are rising, positive correlations may be less concerning. This insight underscores the importance of maintaining a balanced portfolio to navigate different economic cycles effectively.
