Correlation
Correlations between asset classes are very important to portfolio managers trying to build a well diversified portfolio. A portfolio of uncorrelated assets with positive expected returns can achieve higher risk adjusted returns. The real benefit comes from assets that have negative correlations as they are most effective at smoothing the volatility of returns.
The most important correlation is the one between the key asset classes; bonds and equities. For most of the last couple of decades, bonds and stocks have moved with a negative correlation. This has meant that bonds have buttressed the portfolio when equities have had significant drawdowns like in 2001, 2008 and 2020. However, since the Covid lows bonds and equities have started to trade more and more in concert. As bond yields rise (bond prices fall) stocks tend to do poorly and vice versa. The chart below demonstrates this effect.
Percentage of US Stocks Positively Correlated to Bonds
Source: Bloomberg Markets “More Stocks and Bonds Are Moving In Tandem, Worrying Some on Wall Street”. Original chart from Societe Generale.
The reason is that inflation is now the key risk for both asset classes. Higher inflation means higher interest rates which feeds through into the present value of all financial assets. The biggest risk to large swathes of the US equity market is a resurgence of inflation, especially given the valuations of many of these stocks are very high relative to history. This situation chimes with earlier periods such as the 1960s and 1970s, where stocks and bonds traded in the same broad trends. The problem for investors in this regime is that they are less well diversified than their lived experience to date.
This is not an easy problem for most investors to address. However, there are a few steps that they can take to improve things. Firstly, they can use cash and short dated debt instead of taking duration risk in the fixed income component of the portfolio. This will at least shield investors from capital losses if rates rise across the curve and reset the income component to prevailing rates in a timely fashion. Secondly, they can look for the areas of the equity market that are still negatively correlated and ensure they have meaningful exposure. Energy and resource stocks come to mind as they tend to do well in inflationary regimes and are minimally represented in most global equity markets. Thirdly, investors can create a diversified portfolio of alpha strategies whose return streams are uncorrelated to the major asset classes. This is challenging for most investors to do, but if done well can be extremely beneficial to portfolios. Finally, they can model historical drawdowns in risk assets and look at what the impact on portfolios would look like without a boost from the fixed income side. If that outcome isn’t tolerable, investors can de-risk until it is, giving themselves a better chance of navigating the cycle.