Global stock and bond comovements - The stylized facts are different

How do global equity and bond returns comovements? This is an interesting question and critical for investors who are global macro traders or just global investors. Nancy Xu tackles this problem in her paper, "Global Risk Aversion and International Return Comovement". The comovement in equity markets are different from bond markets because the reaction to macro risk shocks is different.

Equity return correlations are higher than bond markets, are asymmetric, and show counter-cyclicality. When there is a negative shock, equity markets will show higher correlation. In bad times, all stock markets will move together because they all react the same to a shock that impacts risk aversion. Bond return correlations are lower than equities, symmetric, and show weak pro-cyclicality. Bonds as a safe asset will be less sensitive to macro shocks and given the differences in safety bonds will not have the same downside characteristics.  

Given these stylized facts, the author tries to provide context for why these comovements may different. For bonds, there may be a common term premium. For risky assets, there could be a global financial cycle associated with US monetary policy. Accommodating monetary policy will motivate investors to build cross-border cash flows and leverage that is reversed upon a switch in US monetary policy. Yet, these stories are not based on a common like across assets.

Instead, there is found a strong global risk aversion factor that is link to downside and upside uncertainties of global macro shocks from output growth, inflation and real short rates. Bond comovements are lower because there is a lower response to a risk aversion shock. In fact, bonds which are safe assets may not have any reaction or a negative reaction to a negative risk aversion shock so comovements will show less skew and be more symmetric. For equity markets, the reaction to a risk aversion shock will be the same and thus be stronger in down markets.

Holding a basket of global stocks or bonds will have different diversification properties because each asset class will have a different response to macro volatility shocks.