Looking again at the stock-bond correlation

 

The one issue that has been vexing portfolio managers for years is the correlation between stocks and bonds. Is it positive or negative? if it is negative, bonds serve as a great diversifier even if rates are low. If it is positive, portfolio risk increases and their case for the 60/40 stock-bond mix is called into question. Investors need to know the drivers of this relationship. A recent AQR paper, "A Changing Stock-Bond Correlation: Drivers and Implications" provides more light on this situation. 

The negative correlation of this century is not the norm, so the key question is whether the last 20+ years will continue. Of course, the relationship. has not always been negative in the short-run. Clearly, this correlation is based on macro drivers like growth and inflation which show the distinction between stock and bonds. 

This macro relationships can be structured as growth and inflation shocks or as the sensitivity of returns to the volatility in these macro variables. If we know the signs of these variables, we can judge what will be the covariance and correlation between stocks and bonds. It then becomes a matter of measuring the relative sensitivity of growth and inflation.

When tested in a model, we can predict the correlation and make judgments on the direction. This can be done both for the US or any country. This framework works around world and with specific industries or risk factors. 

The key drivers for prediction the stock-bond correlation are growth risk, inflation risk, and growth-inflation correlation. There is a negative relationship with growth volatility, a positive relationship with inflation volatility, and a negative relation between with the growth-inflation correlation. While the stock-bond correlation is expected to rise, the overall direction for the next year is not clear given the changing volatility for growth and inflation.