Are bonds set to return as a portfolio diversifier?
Investors have recently questioned the role of bonds in portfolios as inflation increased and equity-bond correlations rose. However, with inflation coming under control, are bonds set to return?
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Equity-bond correlations, a key cornerstone in the traditional 60/40 portfolio, turned positive in mid-2022 due to elevated inflation resulting from pandemic-era factors. Since then, global central banks have embarked on an aggressive monetary policy campaign to bring down inflation – and after several months of being in wait-and-see mode, we’re starting to see inflation being tamed with the US Federal Reserve confirming its dovish stance at Jackson Hole. It’s certainly not at target levels yet but it’s come a long way from its peak.
So, what are we saying? Will bonds start to play a diversification role in multi-asset portfolios again? We’re starting to see signs on both shorter- and longer-term correlations.
Short-term correlations
When markets sold-off in early August (due to the Bank of Japan hiking rates which caused an unwinding of yen carry trades, also made worse by softening labour market data in the US), equity markets took a beating (the S&P 500 fell -6% between 31 July and 5 August). However, over the same period, bond yields fell (the US treasury index rose +2.2%), which meant that it helped mitigate drawdowns for 60/40 portfolios. Are shorter-term negative correlations making a comeback?
Long-term correlations
As we said earlier, inflation - one of the drivers of the equity-bond correlation - is cooling slowly but steadily. Headline CPI for July surprised -0.1% y/y while core CPI was in line with consensus at 3.2% y/y. This bodes well for the fight against inflation. Based on history, long-term correlations tend to be negative when core CPI is less than 2.5% y/y. If we see inflation decline further, long-term correlations could return to a negative regime.
Conclusion
If the negative equity-bond correlation of the past two decades before the pandemic re-establishes itself, then the role of bonds will shift back to being a diversifier again. A stable economic outlook, alongside the growth-inflation trade off coming back into balance, could be supportive of this happening.
However, there could still be scenarios where equity-bond correlations remain in positive territory even if inflation is no longer the primary concern. For example, investors might be disappointed by the pace of economic normalisation, or there could be increasing concerns about fiscal deficits. In such a scenario, investors will need to thoroughly re-evaluate the role of bonds within their portfolios. Positive equity-bond correlations may undermine traditional diversification strategies, necessitating a reassessment of asset allocation to achieve desired risk-adjusted returns. Engaging in dynamic asset allocation and exploring other hedging instruments might also become essential in navigating this environment.
Profily autorov
Témy