I’ve talked almost incessantly about the reversal of stock/bond return correlations over the past several weeks.
I won’t rehash it all here, but what’s important to understand is that since the late 90s, stock/bond return correlations have been largely negative. In an environment of rising bond yields, you generally want that trend to continue. Why? Well, because if you’re taking capital losses on the bond side of your portfolio, the hope is that outperformance on the equities side will act as a buffer. Thankfully, stocks have risen since the election in November, giving investors some measure of relief from the sharp repricing of yields (i.e. stocks have mitigated the bond selloff).
That said, we saw evidence in 2016 that the correlation between equity and bond returns can turn positive. The danger in 2017 is that we get what some on the sellside call “reflation frustration,” wherein bond yields continue to rise but investors’ expectations for growth aren’t ebullient enough to buoy stocks. In that case, the correlation between the two assets turns positive, leaving few options for those seeking diversification.
Needless to say, if there’s “nowhere to run” (so to speak), you’d expect vol. to spike as investors and money managers alike panic. Well, in yet another example of how traditional relationships have broken down over the past five or so years, we’re seeing evidence that the market isn’t thinking about rising cross-asset correlations the way it used to. Consider the following chart from Citi’s Matt King:
“But doesn’t correlation equal panic?,” Citi asks.
Apparently not. Or at least not for now.
But how long before this mean reverts? And more importantly, when it does, will correlations fall or will vol. rise?