Hidden in plain sight

Map of Turkey through magnifying glass © Naruedom Yaempongsa / 123RF Stock PhotosBond correlations are a “very dull topic,” admits Edouard Senechal, a senior research analyst on the dynamic allocation strategies team at William Blair. And yet, when the correlation between stocks and bonds changes — and the past 50 years has witnessed two shifts — bonds have very different portfolio-stabilizing characteristics.

That these correlations would have an impact is unavoidable, says Senechal. “The risk premia that we use for bond or equity markets are defined by the correlation between bond markets and equity markets,” he notes. “One of the drivers of risk premia is the correlation with the global asset market, and the global asset market is mostly driven by equities because equities are much more volatile than bonds.”

In a discounted cash flow model, he explains, “increasing real growth is neutral for bonds, doesn’t do anything for your cash flow, doesn’t do anything for your discount rate, and is good for equities.” Normally, he adds, there should be no growth in correlation if growth is high or low. “Increasing inflation is bad for bonds, neutral for equities. Its impact on correlation: none. Increasing real rates, it’s fairly standard; any financial instrument is negatively impacted by increasing real cash rates.”

But the data only partially confirm the valuation model, he says.

“Real growth rate works like the model. Risk of secular stagnation shouldn’t have an impact. Inflation theoretically should have no impact, against a theoretically very simple understanding of the way stocks and bonds should behave.”

Inflation theory and practice

He finds Turkey a useful counter example. Turkey has an inflation rate of 14 per cent. Turkish equities have dropped 25 per cent this year, while bond yields are up 10 per cent. “So here we have a very strong positive correlation between the bond market and the equity market, and that’s really coming from a very simple point,” he explains. “That inflation, in theory, is neutral. But, in practice, when inflation occurs as the result of economic policy miscalculation, it’s not a desired outcome— it creates a lot of uncertainty for businesses.”

That’s what defined the U.S. in the 1970s and early 1980s when stocks and bonds had a positive correlation. What’s more, “when you have assets that are trading at a higher risk premia level, then risk-conscious investors will think of those assets as being more alike and, therefore, your stock–bond correlation is impacted,” he points out.

By the 2000s, however, that correlation reversed polarity. Still, Senechal notes, that reversal didn’t happen overnight. That’s something to consider, given how pension funds around the world struggle from the pain of having dealt with declining interest rates, increased liabilities, and an outlook of relatively low returns in the future from public equities.