Are investors tracking the wrong dots?
Many investors focus on the Fed’s dot plot for signals to future asset price trends. However, with the Fed now on hold we are witnessing much more interesting ‘dots’ and trends - stock and bond prices.
One of the challenges facing a multi-asset investor is the wide range of asset classes you are required to cover and, critically, how to combine them into a total portfolio. A key requirement for success is the ability to not only find the best assets to provide returns, but also the amount and composition of hedges to complement those exposures through the tough times. Sometimes, we come across aberrations like the current relationship between stock and bond prices which make our lives as multi-asset investors a little easier.
In recent months fixed income and equity investors have been in disagreement with stock and bond prices rallying together (that is, bond yields have declined). Normally stocks rally and bond prices fall as yields rise. However when we have periods of uncertainty coupled with loose policy (and high liquidity) we encounter performance trends like today.
Why does this matter? Even after their strong market rally since the start of the year we are seeing an environment where you can capitalize on the asymmetric payoff of Treasuries. In simpler terms, owning Treasuries has limited downside at the total portfolio level because they are currently not following their historical tendency to sell off when equities are up.
The chart below illustrates this point. We have plotted the last five years of daily observations of the price level of the S&P 500 against the 10-year US Treasury yield. Over long periods (grey dots) as equities have risen the yields of Treasuries have also increases (and the price of Treasuries decreased). This relationship holds during periods of stress like Q4 2018 (blue dots) where the S&P fell almost 20% at one point and yields fell 68bps peak to trough in response.
Price-yield relationship between the S&P 500 and 10-year yields
Source: Bloomberg, Schroders, using five years of daily returns, through April 2019. Past performance is no guarantee of future results. Actual results would differ.
This relationship can change for shorter periods of time, like it did in 2017 (pink dots). The Fed hiked twice in successive quarters (after hiking once in each of the previous calendar years). Monetary policy was still loose (Fed funds <1.25%), but the Treasury market was unsure how the economy would react to this increased pace of hiking while the equity market continued to show strength.
Source: Bloomberg, Schroders, using five years of daily returns, through April 2019. Past performance is no guarantee of future results. Actual results would differ.
The big question we are all facing today is which group of investors are correct? Fixed income or equities?? Unfortunately for me I have no crystal ball. But, being aware of the current relationship means that I don’t need to be 100% right. Either way, Treasuries seem set to provide a useful downside hedge, especially given the modest inflation risk at the moment. So for now, we believe investors can seek upside capture with equities while managing downside exposure with Treasuries, and still get a decent coupon with a highly liquid instrument. The dots do seem to be aligning for investors.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.
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