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Bonds and equities: a new correlation for a new world order

Investment strategy

BNP Paribas Asset Management

Achieving the most effective balance between asset classes is likely no longer a simple ‘equities or bonds’ choice. Other factors – exogenous events and new technologies among them – are bringing new asset classes into the equation.

The question of whether or not investors should shift allocations from equity to bonds is one that comes up almost as often as the S&P500 seems to hit a new high. But is it actually the right question to ask? In my view, there is no strict black or white answer to this question – the answer needs to evolve in line with events.

Looking back, 2017 was a period of historically and almost stubbornly low volatility. By comparison, 2018 was a rollercoaster ending in a December when the S&P500 plunged by almost 16%. Six months later again, equities have come off a two-week losing streak, the US Federal Reserve has taken a pause (and there is even speculation that they will cut rates during the second half of 2019).

So, is this the right moment to take some gains from the 10-year bull market in equities and reallocate? And are bonds the most appropriate asset class to choose?

There has been a prevailing assumption that, over the long term, bonds and equities are negatively correlated. And for much of the 20th century, that assumption held true. Managers of portfolios built several decades ago used this assumption as the basis for shifting from equities to bonds as investors’ risk tolerance decreased, either because they were nearing a period where the portfolio had to pay out or because the market was entering a period of turbulence. However, in the last 10 years, correlations between bonds and equities have become sharply more positive.


Welcome to the new world order! The risk-reward trade-off has shifted

Even more significant is the shift in the risk-reward trade-off, defined as the potential amount an investor would be willing to risk for a potential reward. These risk-reward ratios held up well for decades until recently, when investors came face to face with such market-changing events and new investment technology as the 2008 global financial crisis, crypto-currencies, artificial intelligence (AI), trade wars, Brexit, globalisation, anti-globalisation… the list is long.

These developments have brought about a need to retune traditional benchmarks that have previously guided portfolio construction processes. We have a universe of investment classes and intra-market relationships that have changed the spectrum of risk-reward ratios, not just for the new asset classes, but also the traditional ones.

Nothing underlines this change in market reality so much as the shift in the risk-reward trade-off from equities, which has become nearer that of bonds, i.e. 1:1, in the last 10 years. The US equity market, in particular, has seen the biggest change in this ratio, which has influenced the broader global developed equity markets in a similar way.


Simply moving from equities to bonds may no longer be enough

How does this affect a portfolio combining allocations to bonds and equities? Asset classes exhibiting a similar risk-reward trade-off, with a narrower volatility spectrum in markets where the currency is strong or strengthening, typically see an increase in the correlations between asset classes.

The US market is currently a good example of this phenomenon. In other words, simply shifting out of equities into bonds (or vice versa) may no longer be as an effective defence as it once was against equity market underperformance. I can well envisage that in the near term, for example, emerging market strategies could potentially provide an effective near-term risk-reward trade-off, with returns uncorrelated to those in developed markets.


New asset classes have expanded the risk spectrum

Portfolio diversification is more important than ever as the market grows at an accelerated rate and we see added volatility coming from trade negotiations and political transformations. In addition the new world order that includes crypto-currencies, Artificial Intelligence (AI), big data and other evolving technologies is taking us to a new playing field.

Coupled with this, recent changes to the regulatory environment may benefit income-generating asset classes. This means it could well be worth investors considering moving some of their allocations into higher dividend equities, alternative assets/quantitative strategies/alpha-driven equity, fixed income and/or real assets.

So, I believe investors will need to move past the simplistic equity versus bond choice to one involving a more diverse set of asset classes, and take into account a larger set of variables when it comes to investment decisions. In short, equities and bonds may not retain the same positions in an investment portfolio they once had; the gap between them has narrowed and new asset classes are invading and expanding the risk spectrum.

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