Market Update 29th April 2024

The tortured correlations department

I promise this isn’t going to be another note about the current state of rates and inflation, or where they might be going next, but just by way of introduction late last week the US released seasonally adjusted Q1 GDP of 1.6%, down from 3.4% in Q4 2023 and below expectations of 2.2%. At the same time PCE inflation rose 0.3% in the month, following a similar 0.3% rise in February. This has no doubt already generated many millions of words of commentary which I am reluctant to add to.

What I did want to talk about is what it might mean for bond / equity correlations. Much of modern portfolio theory is predicated on this being negative – bonds go up when equities go down. In reality the correlations are dynamic and vary widely over time, including being positive. 2022 is the most recent and clear example of this, when both asset classes fell sharply at the same time.

I was shown a chart during the week with these correlations going back to 1900. Throughout the twentieth century bonds and equities correlations were mostly positive, but have been negative almost the entire time since 2000.

What drives these changes in correlation? The key issue is inflation, which is why I wanted to start with the PCE inflation numbers. Higher inflation leads to a more positive correlation while lower inflation tends to lead to a negative correlation. The generally negative correlations we have seen over the last few decades have been relatively anomalous vs the longer-term history. Higher and lower in this context means a turning point of around 2.5%-3.0%. This is exactly the range US inflation is in now. Towards the end of last year, the monthly numbers were falling, but in February and March they changed direction and started going back up.

One reason the correlations are dynamic is because they are affected by the reasons for bond yields changing. Broadly speaking if bond yields are rising because of economic growth, without too much inflationary pressure, then equities and other risk assets should be doing well, and they will be negatively correlated.

If it is inflation driving bond yields higher, then this erodes the future value of bond coupons, increases interest rate expectations, and increases the risk premium on equities. This in turn reduces the value of equities in the same way as bonds through a higher discount rate. In other words, they become positively correlated and both will be going down.

Up until now, the consistent narrative around “higher for longer” in the US has been around the GDP growth numbers and very resilient job market. These numbers have stayed relatively strong maybe counterintuitively despite a brutal rate tightening cycle. If the economy has held up like this then rates have to stay high. This is the “no landing” argument we have touched on before, and has helped to drive the likes of Nvidia and the S&P itself to record highs.

You may be aware that both have fallen from those highs. Much of the US economic resilience has come from extremely high deficit spending which is inflationary. If the market starts to think bond yields are being driven by sticky inflation rather than growth, then things may change.

If bonds and equities are positively correlated due to high inflation, then a third way to diversify and protect value is through real assets.

Some real assets on their own do not diversify much from equities, but one fund we like allocates across real estate, commodities, natural resources, gold and infrastructure. By tactically allocating across the different asset classes, they increase diversification to bonds and equities, and produce better risk adjusted returns.

Using proprietary data, they show real estate has a beta of 1.02 to global equities (going back to 1973), natural resources beta is 1.00, infrastructure is 0.74 and commodities are 0.22 – giving a blend of 0.66. In risk reward terms, this equates to an annualised return of 9.2% for blended real assets (again since 1973) with a volatility of 12.0% vs 8.8% annualised return for global equities with a volatility of 15.1%.

If inflation does remain higher, or stays more volatile than it has been in the past, then real assets will increase in importance, and will diversify portfolios in a wide range of market conditions. It is only one set of numbers, but in last week’s scenario of lower growth and higher inflation they become particularly vital.

Robert Fullerton – Senior Research Analyst

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