Hello and Happy Monday,
The markets experienced another bout of volatility, with a significant sell-off on Friday ultimately leading to a flat performance on the week.
I have attached additional commentary for the week from our partners at J.P. Morgan. This article looks back at the reasons for the high correlation between stocks and bonds last year, as both asset classes sold off. The high correlation led to underperformance as investors were not getting the historic benefits of being diversified between stocks and bonds. As we look ahead, the relationship between stocks and bonds should normalize, and once again we should see a negative correlation between the two asset classes that helps to reduce volatility in diversified portfolios.
What is the outlook for the relationship between stocks and bonds?
- When the Federal Reserve began its rate hiking cycle last March, both asset classes sold off significantly, resulting in positive stock/bond correlation and, as a side effect, a distrust of duration.
The role of duration, or exposure to changes in interest rates, in portfolio construction has been a source of great debate. Duration typically applies to fixed-income instruments: when interest rates rise, the value of any existing bond with some duration decreases, resulting in a negative price return and perhaps a negative total return. However, the duration can also be applied to stocks: speculative technology companies, for example, could be considered a high-duration investment if they are heavily reliant on cheap borrowing rates to fuel growth over the short- to medium-term.
At the beginning of 2022, both the U.S. stock and bond markets were highly sensitive to interest rates. Technology and tech-adjacent names made up a significant portion of market capitalization and had ballooned in value, largely due to ultra-low borrowing costs following the financial crisis. Meanwhile, the Federal funds rate sat just above 0%, giving investors no “coupon cushion” in the event that rates started to back up. When the Federal Reserve began its rate hiking cycle last March, both asset classes sold off significantly, resulting in positive stock/bond correlation and, as a side effect, a distrust of duration. It has also raised concerns that stock/bond correlation will be stuck stubbornly north of zero.
However, looking forward, it seems reasonable to assume that this relationship will “normalize” in the year ahead. The recent August CPI inflation print surprised to the upside at the headline level but, stripping away the impact of a supply-related surge in energy prices, core prices continued to moderate. In other words, the long-standing trend of disinflation seems set to continue. This is a welcome sign for Fed officials, who should vote to hold rates steady at the September meeting. At that point, all eyes will be on the revised “Summary of Economic Projections,” particularly the “dot plot”: it will tell investors if the Fed is less concerned about prices than in June and, in turn, if the long-anticipated pivot in policy is closer than previously telegraphed.
Ultimately, this pivot is inevitable: since the start of its hiking campaign, the Fed has acknowledged that rates would be taken deliberately into restrictive territory before dropping to a more neutral rate. When the pivot occurs, there is a chance that stock/bond correlation turns negative once more: bonds rally as rates move back down to earth while the equity market, already having anticipated the pivot’s impact on forward earnings, trudges along sideways. Over the long run, though, duration will be an investor’s friend for both asset classes: not only will lower rates push bond prices higher, but a lower opportunity cost of owning equities and easy monetary policy should allow valuations and earnings expectations to move higher.
- Stock/bond correlation during previous interest rate cycles
Federal funds rate, 180-day rolling correlation between the S&P 500 and the Bloomberg Agg