It is on this basis that we advise all investors to build a “balanced” portfolio whose distribution between equities and fixed income oscillates around 50/50. Today, this fundamental proposition no longer holds.
For nearly 30 years beginning in 1966, according to Montreal’s BCA Research, the correlation between stocks and bonds drifted into negative territory, helping to found modern portfolio theory. This negative correlation also prevailed for most of the 20th century. When stocks in a portfolio fell, bonds kept it afloat and vice versa.
However, since 1997, the correlation between the two asset classes has been steadily increasing, and today the two classes often move in tandem. Worse yet, bonds offer a negative yield that falls when stock prices crash.
This idea of a correlation between stocks and bonds is a lure, judge Yanick Desnoyers, vice president and chief economist at Addenda Capital, in Montreal. “The correlation between stocks and bonds is a fortuitous event that characterizes only at a very superficial level the evolution of the prices of the two assets. The financial community talks about correlation, but economists talk more about causality. »
In fact, explains the economist, the two categories of assets obey very different economic imperatives that, sometimes, can cause them to be correlated, and other times, not to be. There is no iron law that stocks and bonds must move in divergent directions. When economic and financial conditions require it, their correlation increases, as is currently the case very sharply; and when conditions dictate otherwise, their correlation decreases.
Thus, Yanick Desnoyers designates three variables that dictate the “correlated” or “uncorrelated” relationships between equities and fixed income: economic acceleration or slowdown, rise or fall in inflation, rise or fall in central bank reference rates. “The correlation depends on the economic context”, says the economist. That is why many have been caught since the beginning of the year. »
For example, in a case of economic slowdown and rising inflation, the “correlation” will increase; however, if the economy recovers and inflation falls, the “correlation” will weaken. It all boils down to how inflation and economic recession raise expectations of a deterioration in the future value of returns and affect asset prices.
“Without inflation, and even if there is a recession, a classic 60/40 portfolio will win,” explains Yanick Desnoyers. Stocks are falling, but bonds are doing well: the correlation is weak. Add inflation and we see that both assets fall: the correlation is reversed. »
The third variable, that of the key rate of the central banks, is called to incline the current strong “correlation”. “It can last a little longer, thinks the economist. However, it will reverse with a recession, when key rates are high enough to curb inflation. At that point, the central bank will lower its rates, which will improve bond yields, offsetting losses in the stock market. »
Thus, Yanick Desnoyers expects the US Federal Reserve’s key rate to reach 4.5%. It will be time to dive back into the bond market, a bit before the key rate hits this cyclical peak.