Ignore Shifting Correlations At Your Peril

September 24, 2014

Pre_1999_Returns_Scatter

Post_1999_Returns_Scatter

Simply scanning the plot, we can see that the number of points in the top-left quadrant versus the bottom-left is significantly higher post-1999. While not conclusive, this historical sample suggests that bonds may not serve as a good short-term hedge against equity volatility in high-correlation regimes.

So What's Driving Correlation?

Why the sudden shift in 1998, and what can we learn from this going forward from today's market environment? Like with most assets, the fundamental drivers of return for stocks and bonds will be a combination of inflation expectations, economic growth rates, nominal interest rates and policy.

The sensitivity stocks and bonds have to each of these factors will be different—but when one factor overwhelms all others, correlations between the two asset classes can spike.

The common hypothesis is that this is exactly the regime we saw pre-1999: Inflation, being the primary concern, was the latent factor that led to increased correlation between stocks and bonds. With the moderation of inflation during the 1990s, sensitivities to other return factors took over, particularly those around economic growth.

We can see this break highlighted in the graph below, where historical annual bond yield and earnings yields are plotted. Pre-1998, we see that these yield numbers moved closely in sync with one another. Once the long-inflation cycle has come to an end and the late-90s equity bubble picks up, we see these figures diverge and begin to move in opposite directions.

 

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