UBS: Relationship troubles - the correlation between equities and bonds

• The correlation between asset classes lies at the very core of strategic asset allocation and the search for improved risk-adjusted returns in multi asset portfolios

• We identify four equity/bond correlation ‘regimes’ over the past ninety years of US equity/bond data and further show the sensitivity of the relationship to key macroeconomic variables

• Our analysis reveals that the level of inflation and the volatility of inflation have been the most influential drivers historically to the equity/bond relationship in the US

• A new regime? As output gaps close and inflation edges upwards we expect a higher rolling 5yr equity/bond correlation than investors have been used to for most of the past decade

• Rising term premium in US Treasuries may also reflect investors’ belief that the diversification benefits and safe haven utility of bonds are reducing

• We expect the rolling five year correlation to edge further towards zero but given the on-going structural forces weighing on inflation we do not see markets returning to the strong positive correlation regime of the 1970s to late 1990s

Global investors are learning quickly to be careful what they wish for. Over the past two years equity markets have been supported by accelerating economic growth and by the stronger-than-expected corporate profits that growth has generated.

But as evidence of the global demand impulse broadens and as output gaps in developed economies close, investors have started to consider whether such demand strength can continue without stirring a more meaningful and sustained pick-up in consumer prices than has been evident to-date. Will inflationary pressures require  the Federal Reserve to raise rates quicker and to a higher terminal rate than investors previously thought?

These questions and the shifting macroeconomic narrative have seen the correlation between developed world equities and government bonds oscillate wildly in recent weeks. To multi asset investors this presents both challenge and opportunity.

This month’s Investment Insights considers the long-term correlation between equities and bonds, the macroeconomic catalysts to major multi-year changes in the relationship, and considers the likelihood that we are entering a new regime for equity/bond correlations in the developed world as inflation expectations rise.

The full Investment Insights you will finde here.