Asset allocation has long been a foundation of personal investing. Its diversification of risk and return by allocating among multiple assets classes and sectors with varying historical performance patterns can provide an attractive overall investment profile that can mitigate downside risk. In essence, the whole portfolio becomes more appealing than its component parts.
Despite its general acceptance, however, asset allocation has at times endured criticism and headwinds. During the 2008 financial crisis, for example, many investors were surprised at how multiple asset classes moved in tandem in response to market panic and liquidity failures, leading to a reassessment of certain risk practices. Later, risk assets’ correlations (or their tendency to move together) increased with the influence of loose central bank policy and hyper-connected global markets, reducing their value as diversifiers.
Today, with increasing price inflation and the Fed’s gradual withdrawal of monetary accommodation, markets have returned to higher, more normal levels of volatility than had been prevalent in the recent past. This might be considered an ideal time for diversification, but unfortunately we are seeing a potential unwinding of a relationship that has helped asset allocators for years: negative correlations between stocks and bonds.
For almost two decades, investors benefited from a general tendency of these two asset classes to move in different directions, which reduced portfolio volatility and, given the secular bull market in fixed income, enhanced the traditionally lower return profile associated with allocating to lower-risk assets. However, it was easy to forget that the relationship between stocks and bonds has been highly cyclical. Before the current regime, stocks’ correlations with investment grade bonds were positive for much of the 1980s and 1990s, and have generally been slightly positive for the last 40 years overall (see display).
Stock/Bond Correlations Come in Cycles
Stock/Bond Return Correlation
Source: Bloomberg. Stocks and bonds are represented by the S&P 500 and BofA Merrill Lynch Broad Market Fixed Income Index, respectively. Three-year rolling correlations reflect monthly total returns of the two asset classes.
What Makes Correlations Change?
The reasons for such shifts can be complex but typically involve prevailing market and economic conditions. Correlations tend to be negative during periods of low growth and low inflation, and positive when growth and inflation are higher. Positive correlations have generally hit their highest levels toward the end of a business cycle, when central banks attempt to cool down the economy by tightening monetary policy. This hurts existing bonds because their yields become less attractive versus new issuance as rates move higher. Meanwhile, stocks can face headwinds due to companies’ increased financing costs and potential drops in demand, as well as their reduced appeal from a valuation perspective. Specifically, higher yields raise the discount rates with which the market assesses future earnings streams—the higher the discount rate, the lower the theoretical intrinsic value of a company.
Last year’s Fed rate hikes had minimal impact on stocks given enthusiasm about tax cuts and still-loose credit conditions. But this year, inflation- and rates-related news has been more damaging. In early February, strong labor and inflation numbers contributed to a sharp downturn across equities and fixed income. And stocks have generally been more volatile amid pressure on bonds, with more examples of the two asset classes moving in the same direction on the same day. Indeed, the percentage of days the bond market has been down on days when the S&P 500 Index also posted a loss has increased from 36.4% last year to 48.1% so far in 2018. This compares to a 45.6% average rate since April 1989.1
As it stands, the Fed anticipates two additional rate increases this year and then three in 2019. The impact on stocks could be dampening, although it depends to some degree on whether strong earnings can offset pressure from higher rates. For bonds, conditions will likely continue to be a challenge. If the next four rate hikes equate to a one percentage point increase in the 10-year Treasury yield, at current levels that would translate into an approximate 8.5% price decline.2 Individual investors tend to be diversified, of course, but the “marked-to-market” impacts could still be negative, even more so if coupled with a drop in stocks.
Taking Shifting Conditions Into Account
How then should all this affect how investors think about asset allocation? Happily, for investors with well-constructed portfolios the general answer should be “not much.” Taking a step back, in our view asset allocation should be individualized based on a thorough discussion of your financial situation, including your risk tolerance and specific investment goals and objectives. What this means is that it shouldn’t hinge on a particular set of economic and market scenarios. It should have breathing room on the up- and downside to be truly effective.
That being said, the assumptions that go into an asset allocation model need to be educated and should account for things like changes in correlations. It’s worth noting that the inputs into a strategic allocation are by definition long term in nature. As a result, the variable character of the overall stock/bond relationship is likely to be captured as part of a large data set, while newer, shorter-term fluctuations are taken into account on an incremental basis.
There are some things investors can do. While having strategic long-term allocations is key, we favor asset allocations that allow for short-term tactical shifts (within defined ranges) that provide the ability to capitalize on shorter-term market dynamics. For example, it may make sense to lighten up on long-term Treasuries and other securities that are particularly vulnerable to rising interest rates, or introduce assets with a strong relationship to inflation or higher rates to offset potential weakness elsewhere in the asset mix. Looking at our Asset Allocation Committee views, within its 12-month outlook it currently has an overweight stance on emerging markets debt and equity, an underweight view of global bonds, and favors Treasury Inflation-Protected securities given current inflation risks.3 An asset allocation framework that allows for tactical shifts can enable investors to express these types of short-term views in their portfolios. (See the Committee views here.)
Beyond such tactical shifts, investors can consider broadening the universe of assets in which they look to invest. This could include a range of fixed income sectors—whether municipals, corporates, mortgage-backed securities or emerging markets debt—but also alternative investments. Private equity and hedge fund strategies, for example, often have risk/return characteristics that are quite different from traditional securities, and thus could help enhance the risk/return profile of an overall portfolio. And put-writing strategies, which sell downside protection in stocks in exchange for a premium, can provide equity market participation with lower volatility.
Keeping Movements in Context
In thinking about these issues, it’s worth keeping in mind that, at a basic level, asset allocation modeling relies on three key variables: return, risk and correlation. Generally, this combined stew serves up an “efficient” mix of assets, which is designed to optimize return potential for a given level of risk. As noted above, when assets tend to move together (correlation) that will typically reduce the effectiveness of portfolio diversification. However, the magnitude of such movements (risk) is also important. So, for example, although short- or intermediate-term municipal bonds may fall in price along with equities due to inflation news, they may fall less, cushioning the blow of a down market. By the same token, low correlations aren’t attractive in isolation. Assets that bounce around like ping-pong balls may not enhance overall portfolio returns, while their volatility could hamper compounding (see display).
Larger Declines Require Larger Recoveries
Source: Neuberger Berman.
Circling back to the role of bonds, Treasuries endure a lot of criticism for their low yields and exposure to monetary tightening. Along with other quality bonds, however, many investors view them as a “safe haven” in times of crisis, contributing to their lower correlation to stocks than investment grade fixed income overall (see display). In the event of geopolitical conflict or escalating trade wars, investors have tended to seek out Treasuries and other quality bonds until the storm has passed. In terms of rates, it is worth reiterating that, as they go up, so does the potential return of new, higher-yielding bond purchases, whether in a laddered or actively managed strategy.
Treasuries’ Added Diversification Benefit
Three-Year Correlations Across Economic Cycles, December 1978 – May 2018
(7 – 10 Years)
|Dec. 1978 – July 1980||0.45||0.42|
|August 1980 – Nov. 1982||0.30||0.23|
|Dec. 1982 – Mar. 1991||0.34||0.31|
|April 1991 – Nov. 2001||0.42||0.38|
|Dec. 2001 – June 2009||-0.19||-0.33|
|July 2009 – Current||-0.06||-0.32|
Source: Bloomberg, NBER. Stocks are represented by the S&P 500, bonds by the BofA Merrill Lynch Broad Market Fixed Income Index, and Treasuries by the ICE BofA Merrill Lynch 7-10 Year U.S. Treasury Index.
Investors who see a decline in the value of their bond holdings naturally won’t be happy about it, especially if it comes at a time of higher equity volatility. But such changes need to be looked at in the context of an overall asset allocation. The different characteristics of some assets could help dampen the negative impact of others in a given market environment. If developed carefully, with personalized needs, risk tolerance and time horizon in mind, your overall portfolio could be more appealing than its individual parts, providing a halo effect that could improve your ability to ride out market turbulence while seeking to achieve long-term goals.