"We know the correlation between stocks and bonds is .3. We just don’t know the sign." -Fisher Black
Any investors interested in ensuring a diversified portfolio should look for other alternatives as protection against a change in the stock/bond mix.
Fisher Black was not exactly true with his observation, but it is a great comment on one of the enduring investment relationships that nevertheless can change quickly and hurt investors. The stock/bond correlation is negative until it is not and the impact on portfolio diversification will be significant even if volatility We have been living in a negative correlation world between stocks and bonds since the Financial Crisis with only short punctuations of positive correlation.
This negative correlation has been the key driver for portfolio diversification for most investors. The "enduring" benefit of the 60/40 stock/bond portfolio has been driven by this inverse relationship. The driver of risk parity portfolios has been the negative correlation between stocks and bonds. Many investors have laughed at the silliness of investing in hedge funds when a bond portfolio has provided more diversification benefits and a nice gain as rates marched lower.
We are not forecasting any immediate change in this relationship, but the yield gain and return boost from declining rates is limited. Rates could go negative, but return dispersion may decline as rate markets move closer to zero. The bond term premium has been estimated to be negative, so there is less room for this premium to move favorably for investors. Treasury debt supply is increasing and foreign central bank buying has been curtailed. All of these factors can place upward pressure on the stock/bond relationship.
This negative correlation has been the key driver for portfolio diversification for most investors. The "enduring" benefit of the 60/40 stock/bond portfolio has been driven by this inverse relationship. The driver of risk parity portfolios has been the negative correlation between stocks and bonds. Many investors have laughed at the silliness of investing in hedge funds when a bond portfolio has provided more diversification benefits and a nice gain as rates marched lower.
We are not forecasting any immediate change in this relationship, but the yield gain and return boost from declining rates is limited. Rates could go negative, but return dispersion may decline as rate markets move closer to zero. The bond term premium has been estimated to be negative, so there is less room for this premium to move favorably for investors. Treasury debt supply is increasing and foreign central bank buying has been curtailed. All of these factors can place upward pressure on the stock/bond relationship.
Any investors interested in ensuring a diversified portfolio should look for other alternatives as protection against a change in the stock/bond mix.
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