Horvitz Levy Attornies

What’s the impact of the stock:bond correlation?

The correlation between stocks and bonds in a rising interest rate environment can turn positive. So given the likelihood of a rate rise, what should asset allocation look like if investors are forward looking?


One of the growing trends in asset and risk allocations is to adopt a forward-looking view driven by macroeconomics, rather than a backward-driven view generated by historical statistics.

This is particularly important in the context of a likely rise in interest rates, something a backward-looking view would not incorporate, and the impact that would have on the stock:bond correlation.

Executive vice president and global head of client analytics at Pimco Sebastien Page, says the macroeconomic factors should be a consideration for investors in their asset allocation decision-making, and in the current environment there is a potential change in the stock:bond correlation that could have a significant impact on asset allocation.

“There has been a declining interest rates environment for 20 years and asset class returns and volatilities reflect that. Forward looking, given yields and P:E ratios, likely returns are different and interest rates increases will mean a different asset allocation,” he says. “It is clear in a high interest rate environment there is very different diversification between stocks and bonds, the correlation can turn positive.”

This has implications for how investors hedge risks and for the role of bonds.

A quantitative research piece Page co-authored with four other Pimco colleagues, The Stock-Bond Correlation, shows that from 1927 to 2012 the correlation between the S&P500 and long-term Treasuries has changed sign 29 times, ranging from -93 per cent to +86 per cent.

The paper states that while many factors influence the stock-bond correlation, analysis reveals the importance of four key macroeconomic factors: real interest rates, inflation, unemployment and growth.

The authors say that stocks and bonds have the same sign sensitivity to the real (inflation-adjusted) policy rate and to inflation, while their sensitivity to growth and unemployment have opposite signs. So depending on which factors dominate, the correlation can be positive or negative.

“If growth concerns, such as unemployment or GDP drive volatility, then the correlation can be expected to be more negative,” Page says. “If surprises in interest rates and inflation dominate volatility then you can get a positive stock:bond correlation. Bonds are not hedging as well as they used to.”

“Investors don’t always pay attention to this but it plays a huge part in, for example, risk parity volatility,” he says.

At the same time the stock:bond correlation could be changing, an allocation to alternatives may not be the saviour for portfolio diversification and risk hedging.

In a recent FAJ paper, “Asset allocation: risk models for alternative investments”, Page and his co-authors join a growing academic literature which finds there is no longer a “free lunch” in using alternatives.

The paper runs through analysis of an alternative risk framework to mean-variance optimisation and shows alternatives are exposed to many of the same risk factors that drive stock and bond returns.

“Our paper shows reflecting true mark to market risk would result in lower allocations to alternatives,” he says.

Page recently presented at the CFA Institute annual conference on asset and risk allocation trends, and while the concepts are not new, they are worth noting, because of the momentum with which they are trending.

He says first, rather than relying on a backward-driven view generated by historical statistics, investors should formulate a forward-looking view driven by macroeconomics.

Second, investors should focus on risk factor–based diversification in addition to asset class–based diversification.

Third, investors must recognise the dynamic nature of markets and make asset allocation decisions on a cyclical and secular basis rather than a calendar-year basis.

Finally, risk should not be defined solely as volatility; investors should seek to explicitly measure and manage tail-risk exposures.