07 Nov 2023 4 min read

Correlation is not causation, nor constant

By Bruce White , Fiona Wu

What really determines the correlation between equity and bond returns?


From the early 1990s until 2021, the correlation between equity and bond returns had generally been negative. That changed last year. 2022 delivered negative performance for all asset classes except cash and commodities.

Why the change, and is this the new normal?

Over the long term, the correlation between bonds and equities varies considerably in both magnitude and direction. Simple explanations, such as the level of inflation, don’t account for the variation.

Instead, we need to think about the types of shocks driving the economy and markets. Aggregate demand shocks tend to drive cashflow expectations and discount rates in the same direction. Positive demand shocks push up earnings forecasts and expectations for short-term interest rates. This means that generally, bond and equity prices tend to be inversely correlated in response to such shocks.

In contrast, aggregate supply shocks tend to drive inflation up and output down. For a nominal bond, higher inflation would reduce the value of its cashflows, likely resulting also in a fall in bond prices. Higher costs associated with inflation feed through to businesses and corporates, which typically lead to lower equity prices in this environment too.

The observed correlation between equities and bonds will be determined by which type of shock dominates. Our Economist team’s roadmap points to the growing risks of a recession (demand shock) and a gradual abatement of supply issues, suggesting that equity/bond correlations could move to be negative – a potential silver lining for multi-asset portfolios.

Fixed income implications

The high valuation of global fixed income since the beginning of this millennium may have been partly due to its value as a portfolio diversifier. Research from the Federal Reserve suggests the negative equity/bond correlation could have reduced the bond risk premium on US treasuries by several hundred basis points.

Changes in that correlation make it riskier for investors to hold bonds in their portfolio, so we can conclude that investors must be compensated by a higher bond risk premium.

A return to a negative correlation would therefore be likely to drive down yields again.

A new era?

For a multi-asset portfolio, a positive stock/bond correlation means an increase in the risk profile of the portfolio. If the risk tolerance of the investor remains the same, a reduction in the equity allocation may be required to maintain a constant level of risk.

We believe investors should calibrate their risk-taking considering a range of possible outcomes, not simply what has just occurred. This is why the question of whether we are in a temporary period of high equity/bond correlation or a structural ‘new era’ is important.

On balance, we lean to the former, but acknowledge some more structural inflationary factors that could mean we won’t fully return to the golden age of equity/bond correlation. However, it is important to note that the diversification1 between equities and bonds is just one of the factors that is important in a global portfolio. The relationship between equities and other assets changes all the time.

If we compare the pre-pandemic and post-pandemic periods, bonds now offer less offset to equity risk, but regional equity co-behaviour has become less pronounced over time. That is demonstrated in the chart, showing a progressive decline in the average beta of EAFE and emerging markets to North America (all in US dollar terms).

Average-beta-to-North-America-of-EAFE .png

This is driven in part by the greater weight to China within EM indices and China’s economic and market dynamics decoupling from the US in many respects. This benefits funds where the equities are regionally diversified to a greater extent than those where equities are dominated by North America.

In addition, the US dollar, a sizeable part of many of our funds’ foreign currency exposure, has become more widely appreciated as a ‘risk-off’ currency. That supports our approach to considering foreign currency typically beneficial in portfolio construction. A resilient, diversified portfolio doesn’t rely on one single component working.

In summary, there is no simple conclusion. The equity/bond correlation has changed in a way that is consistent with markets being dominated by concerns about aggregate supply shocks. Although that has weakened a valuable source of diversification, others have grown in importance relative to the pre-pandemic period.

This blog is an extract from our latest AA outlook. Read the full Q4 AA outlook.

1. It should be noted that diversification is no guarantee against a loss in a declining market.

Bruce White

Fund Manager

Bruce is your not-so-Aussie Australian. While seemingly laid back, this serious(ly deadpan) fund manager likes to have trades lined up before most of the team have come in and is not impartial to a little mental acrobatics when it comes to powerpoint slide creation. His socks can be rather colourful…as can his language…

Bruce White

Fiona Wu

Portfolio Manager

Fiona is responsible for structuring liability-driven investment strategies for pension scheme clients. Fiona joined LGIM in 2018 from Aviva Investors, where she held the title of Portfolio Manager. Prior to that, she spent a year at HSBC Life as an actuarial intern. Fiona graduated from the University of Southampton with a first class BSc honours in mathematics, and is a CFA Charterholder.

Fiona Wu