Information regarding growth, inflation, and monetary policy has a significant impact on both bond and equity markets. Bonds typically respond in a predictable manner: news indicating accelerated growth, increased inflation, or higher official interest rates generally leads to higher bond yields and lower bond prices. The relationship with equities, however, is more intricate. Sometimes they react negatively to the prospect of higher interest rates, but other times investors focus on the positive earnings outlook that follows from a strong growth environment that leads central banks to raise rates.
As a result, the relationship between bond prices and equity prices fluctuates over time. This relationship is referred to as correlation, a statistical measure that captures both the strength and direction of movements in different securities or asset classes in relation to each other. This measure is constrained to fall within the range of -1.0 and +1.0. As shown in Chart 1 below, which contains data since December 1930, the five-year rolling equity-bond correlation has fluctuated within a wide range of positive and negative values.
Since 2000, the correlation has been predominantly negative, especially when official interest rates were at the zero lower bound. Combining asset classes that have correlation coefficients below 1.0 – meaning they don’t tend to move in the same direction all the time – can reduce a portfolio’s overall risk profile. Negative correlation means that when equity prices decline, bond prices rise (and hence bond yields decline). An investor who is invested in both asset classes will benefit from a diversification effect: one asset declines in value while the other increases, thereby cushioning the impact. This effect underpins the demand for bonds, even when yields are very low. Multi-asset investors have benefited from the negative correlation between equities and bonds in order to lower portfolio risks and limit downside losses in times of market distress.
However, during the recent Federal Reserve rate tightening cycle, the correlation between equities and bonds has turned positive again. The recent surge in inflation has sparked concerns that we are on the cusp of a possible regime shift. Although such fluctuations are not uncommon in the short term, the macroeconomic and policy backdrop may be slowly shifting in favour of a positive equity-bond correlation. Considering historical data, the possibility of this exists. For example, while the average five-year correlation since 2000 has been negative (-0.2), the longer-term average since 1931 is in fact positive (+0.08). Moreover, the correlation was positive in most five-year periods between 1931-1955 and 1970-1999 (Chart 1).
This is reminiscent of what happened during the rate hike cycle of 2004-2006. This is not a surprise: higher official interest rates cause an increase in bond yields and a decline in bond prices. Higher rates lower the net present value of future earnings, can cause a downward revision of these future earnings, and can weigh on the risk appetite of investors. For all these reasons, equity prices may decline, leading to a positive correlation with bond prices, which have also declined. Investors hence no longer benefit from as much of a diversification effect.
Higher-for-longer rates outlook?
With the economy improving and recession fears all but gone, investors are more concerned about ‘sticky’ inflation and the Fed. Given the current uncertainty over the future path of inflation and interest rates, investors should not assume that the negative correlation relationship over the past two decades will persist.
Many economists are saying that we are in an environment of structurally higher inflation, and interest rates are likely to be higher than they have been in the past two decades as central banks focus on bringing inflation under control. Factors that will determine the course of inflation over the longer term include decarbonisation, demographics, digitalisation and deglobalisation. The net effect of these themes will most likely be inflationary, with significant variation across countries. This can have a material impact on investors and savers because in a higher-inflation world, your wealth is being eroded faster, every year.
Portfolio implications
As macroeconomic uncertainty persists, investors may consider supplementing traditional asset classes (equities and bonds) with additional sources of diversification and return generators. To address the potential diversification shortfall in a scenario of positive equity–bond correlation, one should consider increasing allocations to alternative diversifiers, such as hedge funds. Incorporating hedge funds can help construct a more balanced portfolio of assets, offering a smoother investment journey, and can potentially enhance overall portfolio outcomes.
How can the 36ONE Hedge Fund improve portfolio outcomes?
The 36ONE hedge funds can serve multiple purposes for investors at any time, some of which are especially appealing in the current environment. These include:
- Delivering independent return streams to make a broader portfolio more resilient
- Outperforming when equities and bonds decline – to help mitigate downside risks
- Improving returns for a lower amount of risk taken (as measured by volatility and maximum drawdowns)
Chart 2 above shows the average monthly return over a five year period (60 months in total) of the 36ONE FR Retail Hedge Fund relative to the FTSE/JSE All Share Index (ALSI). We have compared the average returns during the months where the ALSI generated positive returns (33 up months) and negative returns (27 down months). During up months, the fund managed to capture just over a third of the ALSI performance, which is not surprising as the hedge fund is run with a moderate-low equity exposure and hence is not fully invested in equities. More importantly, during the down months, the Fund has protected our clients’ capital to a much greater extent than the ALSI and has managed to generate positive returns when markets are down, resulting in the Fund outperforming the ALSI overall.
Given the absolute return mindset of the 36ONE hedge funds, there is never a wrong time to consider them. If you haven't yet allocated to hedge funds, it's not too late to explore the potential benefits they can offer to your portfolio.