Correlation Kookiness
A look at why traditional investment relationships sometimes break down
"Correlations may well drive to different trends than what we're used to. This doesn't mean it's going to last forever, but it may last longer than most people expect." — Chris Hyzy
When it comes to stock market correlations, investors may point to a number of long-standing “rules” that help guide their investing. Among them: Stock prices and bond prices move in opposite directions, — as do stock prices and oil prices — while stock prices and bond yields move in the same direction, often in lockstep. Of course, most rules have exceptions, and these are no different. We’re going to focus on the last of these three, stock prices and bond yields, because over the past few years their correlation has been far from conventional — sometimes positive, at other times negative, and on occasion seeming to show no relationship at all. (See Exhibit 1.) We believe it’s important for investors to take this correlation “kookiness” into consideration, especially when they’re reallocating portfolio assets for risk or return. As to what’s behind it, there seem to be many more possible influences than there used to be, due in part to the sweeping global shifts we have dubbed “a transforming world.” Here’s a look at a number of these factors.
The Impact of Prolonged Low Interest Rates
A major factor in the fluctuating stock price-bond yield correlation is prolonged low interest rates. “After the credit crisis of 2008, there was an enormous Federal Reserve policy experiment, with effective interest rates moving to zero,” says Christopher M. Hyzy, Chief Investment Officer of Bank of America Global Wealth & Investment Management. “The Fed’s two main goals were to stabilize the financial system and then to expand the balance sheet to further stabilize asset prices.” While Fed action — or in this case inaction — is not unusual, “the Fed has kept interest rates low far longer than almost anyone anticipated,” Hyzy says. As the crisis loomed, the central bank lowered the Fed funds rate in increments, dropping it from 4.25% in December 2007 (before the crash) to a range of 0.0%-0.25% in December 2008 (after the crash). And now, almost a decade later, while the rate has increased somewhat, as of June 15, 2017, it was still just 1.00%-1.25%.1
The Stock Price-Bond Yield Relationship in a Nutshell
Stock prices and bond yields often move in lockstep because in an improving economy many investors reallocate money from bonds to equities, accepting more risk in a search for higher returns. As a result, stock prices typically move up and bond prices down, and bond yields almost inevitably move in the other direction to bond prices. Conversely, when the economy is cooling, many investors will do the opposite, moving into bonds in a search for safety, thereby helping push bond prices up and stock prices and bond yields down. A key influence is the Federal Reserve, which normally lowers or raises core interest rates — which themselves can affect bond yields — in search of an economy in the "Goldilocks zone," neither deflationary nor hyper inflationary.
The story is similar elsewhere. Post-crisis, the Bank of England (BoE), the Bank of Japan (BoJ), the European Central Bank (ECB) and other central banks all lowered key interest rates to zero, with a goal of creating a pool of cheap liquidity that would ultimately help lead to a functioning global economy. Now, as in the U.S., many of those rates remain low or at zero, and Hyzy does not expect the situation to change anytime soon. “We think central banks will maintain their accommodative policies for some time, with the U.S. starting to normalize first,” he says. “Once rates do eventually rise, we would expect fixed income to ‘grind out’ a recovery over time. We’d also expect the stock price-bond yield relationship to become more stable.”
Central banks have also built up their post-crisis balance sheets, with the Fed’s, for example, growing five-fold, from about $893 billion in June 2008 to $4.5 trillion in June 2017.2 The four main central banks — the Fed, BoE, BoJ and ECB — have total assets of some $14.5 trillion, an unusually large amount that they may partly channel back into the economy, once conditions are right. (See Exhibit 2 for central bank balance sheet growth.) “Once central banks normalize policy, we should see them wean themselves off their large pools of liquidity,” Hyzy says. This action could in turn influence traditional investment correlations.
A Shift in Economic Drivers
Another element creating correlation kookiness may be a shift in what’s driving major economies. “China recently moved from a manufacturing-based economy to a consumer- and service-led economy,” says Hyzy, “which, almost by default, has less productivity in it. The U.S. appears to be in a modest transition, from an economy driven by consumer spending on goods to consumer spending on travel and experiences.” Then, of course, there’s technological innovation, which is helping push down global costs in a range of industries. In oil and gas extraction, for example, the use of novel techniques such as hydraulic fracturing (“fracking”), horizontal drilling and 3D scanning helped push down crude oil prices from above $130 per barrel in June 2008 to below $50 in June 2017.3
And because shifts like these may not yet be incorporated fully into productivity data, inflation and growth estimates, which are partly based on that data, may be somewhat inaccurate, helping lead to a continuing central-bank focus on low rates and liquidity.
Sovereign Wealth Looks for Yield
Emerging or growth markets may also have affected the traditional correlations. Many of those nations, especially those that produce oil and gas, “have created sovereign wealth funds that are growing rapidly and potentially seeking yield, with less risk,” says John C. Veit, a senior investment strategist at U.S. Trust, a senior investment strategist at Merrill Lynch. “Since that usually means fixed income, they were at least partly responsible for recent large flows into bonds, even as other investors were seeking to benefit from a rising stock market.” (Total SWF assets grew from $6.2 trillion in December 2012 to $7.4 trillion in December 2016, according to the Sovereign Wealth Fund Institute, with 57% oil and gas related and 43% other related.) “Usually you’d expect either stocks or bonds to attract the lion’s share of investor money, depending on circumstances. Here we’ve seen both,” Veit says.
As an example of money moving into fixed income, assets managed in global fixed-income exchange-traded funds quadrupled, to $625 billion, from December 2010 to February 2017, according to reporting from Bloomberg. Meanwhile, highlighting flows into equities, the Standard & Poor’s 500-stock index rose by almost 25% in just one year, from around 2,000 in June 2016 to 2,439 in June 2017.
Next Steps for Investors
With so many plates spinning simultaneously, “correlations may well drive to different trends than what we’re used to,” Hyzy says. “This doesn’t mean the situation is going to last forever, but it may last longer than most people expect, and perhaps even occur more frequently.” In response, he says, investors should stick to fundamentals and focus on the profit cycle, including in non-U.S. investments, because positive growth surprises may occur more frequent there. “They should also consider more frequent portfolio rebalancing and a greater spectrum of diversification across asset classes, real assets and geographies,” Veit adds. Lastly, keep an eye on global inflation, as a rise there will indicate that central bank policies around the world are starting to return to more normal monetary policies. “That, in turn,” Hyzy says, “should mean that traditional correlations would be more likely to resume.”
1 The Federal Reserve data, 2017.
2 BofA Merrill Lynch Global Research, July 12, 2017.
3 Prices for West Texas Intermediate crude oil, U.S. Energy Information Agency, 2017.
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