by Marco Bonaviri, Senior Portfolio Manager at REYL & Cie
Since the beginning of the year, US 10-year Treasury yields have increased from 2.4% to 3.1%, driving the year- to-date return in these bonds– which have been considered a safe asset for over 30 years now- beyond -4%. Furthermore, during Q1 2018, for only the fifth time in 20 years and the first time in almost 10 years, US sovereign bonds fell in tandem with equities by more than 1%. More generally, the number of downturns in equities and bonds1 occurring simultaneously among developed markets has trended higher lately. Are we at the dawn of a change in paradigm in the relationship between equities and bonds, which could have major implications for multi-asset class portfolios – also known as “balanced” portfolios?
Asset allocation, i.e. the proportion allocated to each asset class, is the very essence of the dilemma facing most investors. It also represents the core business of wealth managers. The objective of the allocation process is to achieve a level of diversification which enables a reduction in portfolio risk and optimises risk-adjusted returns. However, the benefits provided by diversification depend on the relationship between asset classes, gauged notably by the statistical concept of correlation, which determines the direction and strength of the relationship between two variables. The viability of the portfolio construction process therefore draws heavily on the correlation between equities and bonds, which are the two major components in balanced portfolios. Ideally, this correlation would be negative, enabling bonds to partially offset equity drawdowns and reduce portfolio volatility. Meanwhile, the negative contribution from bonds to portfolio returns during bullish equities/bearish bonds phases should remain marginal.
Globally, there has been a negative correlation 2 between equities and bonds for more than 20 years in most developed economies 3. Multi-asset class investors have therefore been able to rely on the complementary performances staged by equities and bonds- the yin and the yang of the financial markets- enabling a reduction in both volatility and drawdowns. Moreover, the spectacular bull market observed among bonds over the past 30 years or so has enabled risk reduction for a negligible cost in terms of performance. Since 2000, the benefits of diversification between equities and bonds have been particularly notable during periods of financial crisis (2000-2002, 2007-2009), with bond allocations acting as a key stabilising factor in portfolios.
The negative correlation which has prevailed over the past several decades gradually led portfolio managers to rely on the benefits of diversifying between equities and bonds, to the extent of ascribing to this strategy the status of absolute truth, based on the flight-to-quality narrative. According to this almost dogmatic rationale, bonds are always inversely correlated to equities and must therefore represent the main (and often the only) risk management measure. As the Nobel prize-winning behavioral economist Daniel Kahneman highlighted, people naturally need to understand the world in simplified narratives, which can sometimes interfere with rational decision-taking processes. As is the case with all types of dogma, this thought process is harmful, particularly since finance remains a human science.
Financial reality is, of course, more complex. Acknowledging that correlations are dynamic and can change over time is essential to the portfolio construction process. The wealth of academic research devoted to this subject has revealed no less than four different stock-bond correlation regimes in the US during the past 90 years, all characterized by a specific macroeconomic context and spanning several decades. Since the global financial crisis, massive intervention by central banks via quantitative easing programmes has heavily impacted certain economic variables influencing the level of correlation between equities and bonds. One hypothesis formulated from recent studies claims that inflation and its volatility are determining factors in the equities- bonds relationship. On the one hand, rising inflation negatively impacts nominal bonds and, on the other hand, macroeconomic uncertainty triggered by inflation volatility weighs on equity valuation.
In the current global context of tapering monetary stimulus measures within a mature economic cycle, we believe that a normalisation of certain economic factors is probable: gradual rise in inflation, heightened volatility of the latter and macroeconomic data, higher equity volatility regime and rising short-term rates. This situation would imply an increase in the correlation between equities and bonds and a decrease in the diversifying power of bonds. Given the current level of bond yields – which appear to have reached a secular low point in 2016 – and their upward trend, the capacity of bonds to offset an equity drawdown is diminishing and the asset class could even weigh on portfolio returns. To illustrate this point, a drop of 120 basis points would be required in current US 10- year yields (i.e. to below 2%) to fully offset a 10% downturn in equities in an equally-weighted portfolio. The situation is different in the Eurozone where there has been a positive correlation between equities and bonds for over 3 years now, and where bond yields have been unattractive for quite some time. Consequently, most investors are already heavily underweight in this asset class which, fortunately, has nonetheless gained over 3% during this period.
With the possibility of seeing the diversifying virtues of bonds evaporate, the question of their exclusion from a balanced portfolio now has to be considered. This is particularly the case as other sources of diversification and alternative risk management mechanisms are now accessible to most investors. These alternative sources of diversification may also have some major advantages: attractive valuation, stable low or inverse correlation with equities, increasing diversifying powers when needed during bearish equity phases. Examples of these instruments include certain alternative strategies (relative value), some currency pairs (short AUD/JPY), long volatility strategies and relative value equity strategies (long defensive sectors/short market).
The correlation between equities and bonds – the cornerstone of traditional balanced portfolio construction – is unstable throughout economic regimes, and investors would be wiser to no longer assume that bonds will continue to protect their equity exposure in the future. Although we are not predicting an imminent return of a positive4 correlation regime between equities and bonds, which would require an overhaul of strategic asset allocations, it would undoubtedly be more prudent to take the initiative and consider this correlation to be zero. In the end, sustaining a traditional equities/bonds mix as a primary source of diversification and risk reduction amounts to implicitly betting that the negative correlation regime in place over the past 20 years will endure. Changes in correlation regimes, a long-term phenomena in general, however have the potential to do more harm than a rise in volatility. Multi-asset class investors should consider alternative sources of diversification in order to maintain a truly “balanced” portfolio. We also believe it is essential to complement this broader diversification with active risk management.
- In this article the term “bonds” refers to sovereign 10-year bonds, which generally incur low default risk and serve as a benchmark for high-quality bonds.
- We measure the correlation between equities and bonds on a 5-year rolling basis with monthly data.
- The correlation in the Eurozone has been positive since 2015.
- According to one current theory, a significant increase in inflationary pressures and macroeconomic volatility could lead to a positive equities-bonds correlation regime.
Dollar edges lower as investors favor higher-risk currencies
By Stephen Culp
NEW YORK (Reuters) – The dollar lost ground on Friday as market participants favored currencies associated with risk-on sentiment over the safe-haven greenback.
Risk appetite was stoked by better-than-expected economic data and expectations that U.S. President Joe Biden’s proposed $1.9 trillion coronavirus relief package will come to fruition.
“The dollar’s down against other currencies but not by a whole lot,” said Oliver Pursche, president of Bronson Meadows Capital Management in Fairfield, Connecticut. “I expect the dollar to be where it is now at the end of the year, and the main reason for that is while I see some signs of improvement in the economy, monetary policy is going to stay where it is.”
“I don’t think the dollar is underpriced or overpriced,” Pursche added.
For the week, the dollar slid about 0.2% against a basket of world currencies, the euro was essentially flat, and the yen lost more than 0.5%. But the British pound advanced more than 1.1% against the dollar, its best week since mid-December.
Bitcoin continues soar to record highs. The world’s largest cryptocurrency was last up 6.6% at $54,961.67, hitting $1 trillion in market capitalization.
Its smaller rival, ethereum, was last up 0.7% at $1,953.28.
The digital currencies have gained about 89% and 1,420%, respectively, year to date, leading some analysts to warn of a speculative bubble.
“One concern I’ve always had (about cryptocurrencies) is how susceptible they are to manipulation,” Pursche said. “But they’re going to continue to gain legitimacy.”
“While it’s great that Tesla made an investment in bitcoin, I’m more intrigued by Blackrock and other major investment firms taking a hard look at cryptocurrencies as a viable investment.”
The Australian dollar, which is closely linked to commodity prices and the outlook for global growth, was last up 1.21% at $0.7863, touching its highest since March 2018.
The New Zealand dollar also gained, closing in on a more than two-year high, and the Canadian dollar advanced as well.
Sterling, which often benefits from increased risk appetite, rose to an almost three-year high amid Britain’s aggressive vaccination program. It had last gained 0.27% to $1.40.
The euro showed little reaction to a slowdown in factory activity indicated by purchasing manager index data, rising 0.21% to $1.2116.
The yen, gained ground against the dollar and was last at 105.495, creeping above its 200-day moving average for the first time in three days.
(Reporting by Stephen Culp, additonal reporting by Tommy Wilkes; editing by Jonathan Oatis)
Shares rise as cyclical stocks provide support; yields climb
By Saqib Iqbal Ahmed
NEW YORK (Reuters) – A gauge of global equity markets snapped a 3-day losing streak to edge higher on Friday, as the recent selling pressure on high-flying big technology-related stocks eased even as investors showed a preference for economically sensitive cyclical sectors.
Oil prices fell from recent highs as Texas energy companies began preparations to restart oil and gas fields shuttered by freezing weather, while the U.S. Treasury yields extended their recent rise.
The MSCI’s global stock index was up 0.47% at 681.88, after losing ground for three consecutive sessions.
On Wall Street, stocks steadied as cyclical sectors edged higher while tech names made modest advances after concerns about elevated valuations led to some selling in recent sessions.
“What we saw (this week) represents a market that is tired and may not do very much. So we are headed for some sort of a pullback, but I don’t think we’re there just yet,” said Peter Cardillo, chief market economist at Spartan Capital Securities in New York.
“Investors are not really pulling out of the market, but they are becoming more cautious. It already has factored in another good positive earnings season.”
The Dow Jones Industrial Average rose 119.97 points, or 0.38%, to 31,613.31, the S&P 500 gained 12.93 points, or 0.33%, to 3,926.9 and the Nasdaq Composite added 92.58 points, or 0.67%, to 13,957.93.
The S&P 500 technology and communication services sectors, housing high-value growth stocks, were among the smallest gainers in early trading, while financials, industrials, energy and materials rose more than 1%.
European shares edged higher on Friday as an upbeat earnings report from Hermes boosted confidence in a broader economic recovery. The pan-European STOXX 600 index was 0.64% higher.
U.S. Treasury yields on the longer end of the curve rose to new one-year highs on Friday as improved risk appetite boosted Wall Street, while the yield on 30-year inflation-protected securities (TIPS) turned positive for the first time since June.
Core bond yields have pushed higher globally, led by the so-called reflation trade, where investors wager on a pick-up in growth and inflation. Growing momentum for coronavirus vaccine programs and hopes of massive fiscal spending under U.S. President Joe Biden have spurred reflation trades.
The benchmark 10-year yield was last up 5.1 basis points at 1.338%, its highest level since Feb. 26, 2020.
Oil prices retreated from recent highs for a second day on Friday as Texas energy companies began preparations to restart oil and gas fields shuttered by freezing weather.
Unusually cold weather in Texas and the Plains states curtailed up to 4 million barrels per day (bpd) of crude oil production and 21 billion cubic feet of natural gas, analysts estimated.
Brent crude futures were down 28 cents, or 0.44%, at $63.65 a barrel, while U.S. West Texas Intermediate (WTI) crude futures fell 66 cents, or 1.09%, to $59.86.
Copper jumped to its highest in more than nine years on Friday and towards a third straight weekly gain as tight supplies and bullish sentiment towards base metals continued after the Chinese New Year.
Spot gold XAU= was down 0.58% at $1,785.71 an ounce.
The dollar lost ground on Friday, extending Thursday’s decline as improved risk appetite sapped demand for the safe-haven currency and drew buyers to riskier, higher-yielding currencies. The dollar index was off 0.295%.
Bitcoin hit yet another record high on Friday, hitting a market capitalization of $1 trillion, blithely shrugging off analyst warnings that it is an “economic side show” and a poor hedge against a fall in stock prices.
(Reporting by Saqib Iqbal Ahmed; Editing by Nick Zieminski)
Oil falls after surging past $65 on Texas freeze
By Stephanie Kelly
NEW YORK (Reuters) – Oil prices fell on Thursday despite a sharp drop in U.S. crude inventories, as market participants took profits following days of buying spurred by a cold snap in the largest U.S. energy-producing state.
Brent crude fell 41 cents, or 0.6%, to settle at $63.93 a barrel. During the session it rose as high as $65.52, its highest since January 2020.
U.S. West Texas Intermediate (WTI) crude futures fell 62 cents, or 1%, to settle at $60.52 a barrel, after earlier reaching $62.26, the highest since January 2020.
Brent had gained for four straight sessions before Thursday, while WTI had risen for three.
“The market probably got a little bit ahead of itself,” said Phil Flynn, a senior analyst at Price Futures Group in Chicago. “But make no mistake, this selloff in oil doesn’t solve the problems. The problems are going to persist.”
Though some Texas households had power restored on Thursday, the state entered its sixth day of a cold freeze. It has grappled with refining outages and oil and gas shut-ins that rippled beyond its border into Mexico.
The weather has shut in about one-fifth of the nation’s refining capacity and closed oil and natural gas production across the state.
“The temporary outage will help to accelerate U.S. oil inventories down towards the five-year average quicker than expected,” SEB chief commodities analyst Bjarne Schieldrop said.
Prices dropped despite a decrease in U.S. oil inventories. Crude stockpiles fell by 7.3 million barrels in the week to Feb. 12, the Energy Information Administration said on Thursday, compared with analysts’ expectations for an decrease of 2.4 million barrels.
Crude exports rose to 3.9 million barrels per day, the highest since March, EIA said.
“The big nugget was the big jump in exports of crude oil,” said John Kilduff, partner at Again Capital in New York. “We’ll have to see what happens with that next week weather in Texas, but I have been looking for a pickup there for a while.”
Oil’s rally in recent months has also been supported by a tightening of global supplies, due largely to production cuts from the Organization of the Petroleum Exporting Countries (OPEC) and allied producers in the OPEC+ grouping, which includes Russia.
OPEC+ sources told Reuters the group’s producers are likely to ease curbs on supply after April given the recovery in prices.
(Additional reporting by Yuka Obayashi in Tokyo; editing by Emelia Sithole-Matarise, Steve Orlofsky, David Gregorio and Jonathan Oatis)
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