The stock/bond return correlation has turned positive which is the largest threat to any diversified manager. Whether this relationship lasts is now the important question since a large correlation flip does not happen that often. We have been in a 20-year period of negative correlation after a 35-year period of positive correlation. Nevertheless, we have signs to help us answer the diversification question.
A breakdown of the drivers of the covariance between stock and bond can be seen in three major components: the variance of the discount rate, the covariance between cash flows and rates, and the covariance between equity and bond risk premia. The impact of rising rates is positive on covariance. A rise in rates will reduces the discounted value of cash flows for any investment. The relationship between cash flows and rates is ambiguous because it depends on the relationship between economic growth and interest rates. The growth and rate relationship is tied to economic policy reactions and growth. The final key driver of covariance is the relationship of risk premia between stocks and bonds which changes with volatility and risk aversion. A shock and flight to safety will force the relationship to turn negative, but that may not be a permanent relationship.
These covariance factors will be affected by the interaction between monetary and fiscal policy and economic activity, so this should be where we focus our time. If monetary policy is used to combat inflation in a rules-based approach as described by the Taylor Rule, then rates will rise with economic activity to stop inflation which will lead to a negative correlation between equity and bond returns. On the other hand, if monetary and fiscal policy are coordinated and used to enhance growth over inflation there will be a positive stock/bond correlation.
The macro policy regime will define the stock/bond correlation and this is forward-looking and not just a function of past history.
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