by Eric Knutzen, CIO, Multi-Asset Class, Neuberger Berman
In case you had forgotten since February, last week was a reminder that we have moved into a higher-volatility environment in which stocks and bonds are becoming increasingly correlated, and, therefore, government bonds are likely to provide less diversification relative to equities.
Wednesday’s 2 – 3% slump across global stock markets was merely the toughest day in a weeklong sell-off. The S&P 500 did not fall more than 2% on any day during 2017—it has done so seven times this year. What was the trigger to dump equities? The run-up in bond yields that culminated on October 3.
Our forthcoming Asset Allocation Committee Quarterly Outlook looks deeper into the stresses and strains that underlie the current volatility, but for now it is important to recognize that when bonds and equities sell off in lockstep, it raises three questions: How long will this correlation regime last? Does it signal the end of the business cycle? And how can investors maintain diversification in their portfolios?
Correlation Regime
We think this change in correlations will likely persist and may even increase through 2019. Historically, positive correlations have characterized the later stages of business cycles. At current levels of U.S. growth and inflation, that history suggests we could see stock-bond correlation of around 0.15 – 0.20, a significant change from the negative correlations to which investors have become accustomed. We anticipate moderately strong growth and higher inflation through 2019, and rising correlations to follow.
On the bonds side, in addition to rising inflation expectations, investors are demanding a higher premium from long-dated bonds to compensate for rising uncertainty about Federal Reserve policy. If the market is right about the path for rates, we think the U.S. 10-year yield will struggle to break 3.5%. However, the Powell Fed’s more data-driven than forecast-driven policy, and intensifying debate about where the terminal rate will be, has heightened risk.
On the equities side, think about how different things are today than they were in February. Global growth was strong and synchronized then, but is weak and U.S.-centric now. Tax-policy stimulus was new then, but is due to wear off now. Trade tariffs were a mere concern then, but are reality now. A repeat of this year’s earnings growth in 2019 seems unlikely, so any equity market rebound would likely be less rapid and confident than it was back in February.
That’s not to say we think rising correlations signal an imminent recession. Should the U.S. continue to power forward in isolation, forcing the Fed to move aggressively before the other central banks are ready to follow, rising U.S. rates and a soaring dollar certainly could tighten the life out of the global business cycle. As our Asset Allocation Committee Quarterly Outlook will make clear, we monitor that scenario closely. However, last week we were reassured in our base case of a more extended cycle by the softening U.S. inflation data, the dollar’s quiet reaction to all the bond and equity market turmoil, and China’s intensifying efforts to maintain loose, liquid and growth-supporting conditions.
A Headache for Asset Allocators
Nonetheless, rising correlations are real and present a headache for asset allocators during periods of volatility such as this.
In bonds, we favor avoiding the long end of the curve, but fair yields and positive total returns remain attainable at the short end. We see some places where there are value cushions: Emerging markets hard currency debt fared relatively well last week because it already had its beating over the summer, for example, and yields are attractive relative to its risk profile, particularly in the shorter duration segment. Inflation-protected securities should suit late-cycle dynamics better than nominal bonds.
In equities, cyclical, value-oriented stocks such as financials or commodity companies may perform better in this environment than quality growth stocks. The “FANG” stocks have come down some 15% from their summer peaks, as bond yields have climbed. Alongside that, investors could look for ways to reproduce lower-volatility equity exposure, but without the interest-rate risk that comes with traditional defensive stocks: Collateralized put option writing or long-short equity strategies could be ways to do that.
To sum up, we do not believe last week was a signal to start battening down the hatches. It was, however, one more reminder that we all need to get smarter and more creative with our asset allocation.
Copyright © Neuberger Berman
