What Investors Should Know About The Correlation Between Bonds And Stocks

I'm pretty sure with that letter hint. Okay, So I just gave it away, which wasn't my intention. But today we're going to talk about correlations. Uh. And correlations historically have been quite difficult for banks and investors to model. And there's one correlation in particular. It's sort of the grand daddy of them all, and it tends to underpin

a lot of investing. And over the past few years, we've seen more and more people start to question whether or not it actually exists in the way that we think it does, and whether or not that correlation, that particular relationship is going to hold true in the future and now I definitely know that you know what I'm

talking about. Right. Of course, a lot of people have portfolios consisting of some slug of equities which are perceived as being risky assets, and some chunk of safety assets like bonds, and over the long uh, well, over the short term, you sort of expect them to move in opposite directions, and so on days when people are scared, your safety ssets rise and your risky ssets fall, and

vice versa on bullish days. But none of this is guaranteed. Basically, just because for some period of time two different assets may have behaved and had some relationship does not necessarily mean that that relationship will persist forever. And hence a good portfolio is not a easy thing to achieve. Right, So you think about a standard portfolio, and the thing that usually comes up is sixty forty, right, that particular breakdown between bonds and equities. It's supposed to be a

diversification play. The two asset classes are supposed to move in different directions. But we have actually seen a couple of times this year where they didn't do that, where bonds and stocks fell in tandem, And of course a bunch of people started asking whether or not this was the start of a historic break in that relationship. So again, this is probably one of the most important correlations in

all of modern investing. Early February we saw that where we saw stocks and bonds get sold off together and basically people who thought of themselves as being prudent diversified investors were left with nowhere to hide. It was just right across the board. Since then, things have mellowed out and diversified investors have done a little bit better, but it did. It does make you wonder whether that was

a warning or at least a message there. Just because you are seemingly diversified does not mean that some part of your portfolio is always going to work or heade against the other parts. Absolutely, So we are going to dig into both those concepts, correlation and diversification, and we have the perfect person who's going to talk about it with us, a guy that's been doing a lot of research on this exact topic. His name is for Ruke Javraj.

He his head of investment Strategies research over at Barclay's. For Ruth, thanks so much for joining us, Thanks for the invitation. So did we get it right? In our intro, is correlation that difficult for people to model? Is it a sort of ongoing intractable issue in finance? That's exactly right. I mean, fundamentally, correlation, irrespective of where you're measuring and across asset classes or across stocks, et cetera, is time varying, and I think we're all very familiar with the fact

now that it varies through time. Historically, there was an opinion about in particular, between the correlation of stocks and bonds, that they were positively correlated, and over the long run, depending upon the sample of data that you're using, you can't find that they were positively correlated during certain periods. But you know, post then there was almost a structural break between the relationships of stocks and bonds and they

became more negatively correlated. Bonds were seen as almost flight to quality asset when risk was off the table. And so ultimately we are seeing that there's more variation in that correlation number through time, which means that it's harder to model, it's more difficult as an input into your portfolio construction methods, and there's because of the increase in the market participation, so there's more investors who are trading stocks and bonds in the market, from institutional through to

retail investors, there's just more noise around estimating this correlation, and so it's a becoming an even more sensitive parameter. I would say, in particular, as you mentioned, between stocks and bonds. I want to go back a little bit because diversification within a portfolio is one of these mantras you always hear, but you always hear it's like, oh, you should be diversified. Maybe some people know what that means to be diversified, others don't. It's a fairly modern concept,

isn't it. This idea of diversification in the last several decades, and this idea of having portfolios with distinctly different behaving asset classes has not always been something that the investment community understood. I think that's a fair assessment. I wouldn't

say diversification is a modern concept. I think at least I've come from a very academic background, having done my PhD in the topic of stop one correlation, by the way, so this is the subject that is very close to my heart, and ever since returns, risk and the relationship between assets have been looked at by the academic community. The principles of diversification have been well known from a

theoretical perspective. I should say, when I met Madern, I met like the last sixty yeah since yeah, okay, so not so. Modern investing has been around for hundreds, but it's really only since the mid nineteen hundreds that people have rigorously approached this idea of what it means to have a diversified part. That's true, and it's become more in focus, you know, as of the last you know,

several decades. In particular, for instance, commodities is being seen as an asset class which can truly diversify your stocks, your bonds, your f X exposure, mainly because it just operates in a completely different way to the traditional asset classes. So I mean, diversification as a concept is very well

understood and intuitive. Of course, you want to know, not put all of your eggs in one basket, but how do you go about doing that is the crux of the problem, and correlations are very much at the focus of how one goes about doing that and the course of that estimation or trying to get it right. In terms of forecasting, correlations is the most important question, and that's that's really where the crux of the issue is.

I e. You know, historically we can look at the realized correlation between asset classes depending upon how we look at the data, and we can see that at various three time. But does that mean what we're inferring from history is going to apply going forward. So there is a kind of mismatch between realized and then expected future correlations, and that is, you know, where most of the research currently exists in trying to really forecast what those correlations are.

So I have a variation of Joe's question before we dig into forecasting correlation, but why did the bondstock split or bondstocks diversification become the sort of standard portfolio model, Like why didn't we have people say I'm going to have stocks and commodities of some sort for instance. Yeah, I mean it's a good question. But stocks and stocks and bonds are the two fundamental asset classes that investors used to use in order to manage their assets and

have growth on over time. So stocks are clearly obvious people are looking to participate in the growth of corporate profits and related economies, and bonds is because that's the other side of the financing equation stocks is equities, bonds is in essence, you know, you're lending money for either government or companies to use it to invest in capex projects.

And so there are two sides of the of the you know, I would say investing coin and those are the two fundamental sides, and they're linked intrinsically by ultimately you know, macroeconomics um and what economies together with sectors and regions are doing. And so that's why stocks and bonds were looked at as the first asset classes to combine together. You mentioned that in more recent times there's been a lot of interest in commodities as a source

of portfolio diversification. What is your view on that, because in addition to sort of being uncorrelated as a key preconditioned to adding from positive diversification, you also have to have some sort of positive expected return because you could add a source of uncorrelation like say betting on baseball games, which won't be tied to the background economy, but that's probably going to be a dragon your portfolio if you're

average gambler. So in your view, do commodities fit the bill where either sufficially uncorrelated and be you can assume that they will add money to your portfolio over some period of time. Yeah, So I mean that's a good question.

Commodities is a very i would say interesting asset class because it evolves basically based upon the applied demand dynamics of individual commodities that are being produced, and so it's almost operates independently because as individuals and societies, we actually have a demand and let's say natural resources, gas oil, et cetera. And you know that's almost separate from how

participants or individuals interact with financial markets. So you have these two different segments of society that people are looking or investing or consuming, and in essence they're not intrinsically linked. Now they've become more so through time as people have looked more to commodities markets to include into their portfolios, as you can imagine. But that's initially why there was

a motivation to include it. But you know, as of the last let's say, you know, five to seven years, our commodities as in focus as they were the last twenty years. No, and that's mainly because we saw the big commodity rise and then crash and as subsequent kind of For instance, the relationship with gold and oil after the global financial crisis has meant their investors haven't naturally used them in the ways that they have done historically.

So it's a very interesting asset class that you know involves almost independently of others, whereas things like credit, for instance, are very much equity like and so those are kind of seen, as I would say, another way to achieve equity light returns. But the average returns historically have been higher in certain regions, and so that's why, you know, commodities were seen as kind as outlier that could be

included in the portfolio for diversification. Right. I just got a flashback to a circa two thousand nine when we had a bunch of commodities funds launching that specifically were aimed at providing uncorrelated returns for investors. But of course those uncorrelated returns turned out to be negative and a bunch of them closed shop soon after. Moving on to the bigger question what we're discussing earlier, why does correlation tend to vary over time? What are the prevailing theories?

What I will say is that from my perspective in the research that I've done. There are almost two different forces at work, the first being kind of a Macari

kind of story. So, in fact, one of my first papers for my PhD was looking at the time variation between the correlation of stocks and bonds using macroeconomic variables, and I did it in a very theoretical way to show that you know, through time there are kind of new information on cash flows two companies, interest rates, and the kind of risk premium i e. You know, what return should be delivered for the risk that you're being

exposed to. That cause for the change in the relationship between stocks and bonds, and these macroeconomic forces, together with interest rates and inflation, cause the variation to to really change through time. Now that's one side of the story. The second is more of a kind of more pragmatic

market practitioner approach. And this is what I was alluding to earlier in that, you know, I would say pre eighties the way the investors interacted with markets is very different from posties and nineties, where almost financial markets were opened up to everyone, retail investors, mom and pop investors

on the street, et cetera. Through the creation of et F vehicles and so now the way that market participants interact with markets is very different from what it was thirty fourty years ago, where it's mainly institutionally driven, and as such that is causing a change in the relationship. So, as you mentioned earlier in February of this year, you know, we saw the stocks and bombs sold off at the same time. Now, that's a very short time frame to

evaluate the relationship. But the point being is it happened we've observed that in practice. Now would we have seen that dynamic if people weren't actively trading the market so frequently as they are now, Perhaps not. But point being is there are these two forces at work, the macroeconomic

story as well as the kind of market participants story. Yeah, I feel like this market participation story and the ease with which people can access these asset classes is probably something we don't discuss enough when thinking about big trends. I'm thinking about how a lot of big institutions, some of the college endowments, they've been very big into by forestry and timberland as basically another asset class that could

be offered diversification. But if I can access the same thing now, you know, at one point I imagine people had to take flights all around the world to inspect a forest and actually sort of make a deal with someone about whether they would get some royalties. Now, I could probably just go onto my brokerage account and invested some forestry e t F and if in February of this year I'm panicking and worried, I'll just sell that along with my stocks and my bonds because I need

to pay my bills. That's a pretty fundamental change in the sort of flows in and out of this market. Yeah, that's right. I mean that's a function of financial innovation. So you have more people looking at creating products linked to things that perhaps are liquid, like forestry or even private equity, And you're right, that ultimately changes the dynamic somewhat.

It creates this perception of, you know, something's happening in the forestry market or the private equity market that we can observe from market variables like an e t F there is linked to a index that is used to try and replicate the exposure to forestry of privorate equity.

But you know, is it genuine, is it true? You know, is it really linked to the underlying fundamentals of that particular asset class quote unquote asset class, and so, you know, it does change the way that investors think and ultimately add exposures into their portfolio. Certainly, so it sounds like we're saying that because of the way that the market has evolved and developed, that correlation regimes have the potential to change more quickly than they had in the past.

But you still kind of needed a trigger in the form of, I guess, a change in the macroeconomic environment. So what should we be looking out for when it comes to, you know, those sorts of triggers in the correlation regime? What have you found to be most valuable? The first thing to say, and it's said by pretty

much everyone, correlation is not causation. And that's why I alluded to the fact that the you know, in my view, there are these two forces at work, the macro story as well as the kind of market story, which are the causation reasons for why we see correlation changing through time and how they interact is obviously a very complicated and interesting thing to observe. But you know, what should

we be looking for? That's a good question. I think ultimately this is certainly probably informed with the work that I've done with Bob Shiller, who's one of our partners on the Barclays COS platform, in that the more data

that you have, the better. I mean, his research work with John Campbell goes back to the eight hundreds where he has a data serve SMP back to seventy one, and I'm a big believer now that we should obtain as much data as possible because then we can almost infer structural relationships between asset classes where we have that data. And as such, if we are then able to monitor

correlation through time on a real time basis. Now because we have daily observations or intra day observations, we can see if there are structural dislocations versus what we've observed in the past. If we observe that, okay, it's a flag, and then we start to look closer at well, why

is that happening? And if we can justify it from a macrec normic perspective or a market participant perspective, then I think we can be comfortable about the changes and the volatility in the correlation numbers that we're seeing, and as such, it then is still a very good and

fundamental input into our portfolio construction techniques, if you will. So, I think knowing well or feeling that we understand what the relationship has been between assets historically and trying to justify why we're seeing changes now is the big part of our kind of the challenges that we have for the investing space, and that's how I would approach that

particular problem. So in light of that, going back to the starks bonds portfolio correlations, it's been really nice for investors that inflation has generally been on the decline for almost forty years because a starks have gone up, but disinflation is just good for bonds, and bond has become

more valuable as flation goes down. In light of the longer term data that you've looked at, how much is the durability of this portfolio and the strength of say sixty forty portfolio, how much is it a function of this very banangn macro environment that we've seen. Ultimately, the sixty forty portfolios designed where it was suggested as a route to diversify equity risk into fixed income risk, and inflation eats ultimately at the real returns that you earn

on your portfolio. And so generally the portfolio has helped by inflation coming down through time. So that's obviously a benefit to the end investor in that particular respect, but also inflation, arguably it is the super interesting variable because at least from my perspective, it's managed far more closely

now than it has been done historically. If you think about central banks, pretty much, they have an inflation target and everything revolves around hitting that target these days, and they use all of their tools at their disposal to

try and do that. And so you know, going back to a place where you know we're going to have, you know, these high inflation numbers I think is I mean, it's always possible, given especially given the period of quantity of easing that we've gone through in the developed economies, but you know, there's so many other forces at work these days, then I'm not sure we will end up

going back to those levels. And so that's something that is of I would say a good thing for the end investor when it comes through to their their overall portfolios. So we've made it this far talking about bonds and stark correlation without mentioning risk parity, but I'm going to ruin it now, so whenever people talk about market correlations, or even whenever they talk about sell offs recently, risk

parity always seems to come up. And there's this notion that risk parity these are strategies sort of balanced portfolio strategies stocks and bonds, where they apply leverage to the bond the fixed income portion of the portfolio to boost returns. There's a notion that risk parity is either in great danger if the correlation regime ever shifts, or that risk parity is somehow going to exacerbate market volatility by sort

of messing with correlations in the market. How do you view risk parity and what is its susceptibility and its relationship with correlation. I mean, that's a good question in terms of its relationship with the correlation. But before answering that, it's good to step back and think about why risk parity basically became into favor and you know what it's

being used for now. So risk party, as a let's say concept, was ultimately a way to increase your exposure two bonds versus stocks, and in essence allocating let's say six to bonds and stocks, so dialing stocks down further, and it's a function. Ultimately, you know, the weights that you're applying the asset classes, or the way that you're applying leverage is a function of, in this case, estimating

the risk from the asset classes. So of course, the risk parity is known very well as the fact that fixed income has a lower risk than equities, so we overweigh equities, sorry, fixed income more versus equities so that we balance the risk contribution coming from each individual asset class. And as such that meant that your overweight bonds relative to equities. Fundamentally, now, ris parity funds did fantastically well during the yields collapsing because obviously bond did well. The

returns to bonds what up. So you know, up until the point where you know, yields are their lowest that we've ever seen historically. For a persistent amount of time since the global financial crisis, there has been this concern that risk parity funds and approaches are not going to be good going forward because we're overweight bonds, but expected returns are lower than they have been historically because yields

have to rise. So with that being said, there's a huge debate on Okay, we understand the popularity of risparity, but we don't necessarily understand the forward popularity of respiraity or the efficacy of that approach going forward. And that's also a function of the fact that the correlation dynamic has changed through time. So historically, you know, the correlation between you know, stocks and bonds was positive. If you could put a little bit more weight on bonds with

deals collapsing, you'll earn more returns. That's great, But now they've become negative. So in essence, they're more diversified as asset classes. But risk parity ignores the expected return component, and they expected return component on bonds in general is lower. So is it sensible to overweight your portfolio to bonds

now given where we are most saying no? And so that's why this is an interesting question, because correlations will inform us that it's good to be diversified across docks and bonds because they have a somewhat negative relationship at the moment, but again vary through time. But the expector returns are not great for bonds, So what does one do and in a risk parity setup that's not really accommodated for And that's why risk parity is something that

is it's certainly a very interesting concept. It's been used successfully in the past, but we really need to question if that's the right approach going forward for our stock bond mix. What about the aspect of the question of whether the parity funds or risk parity strategies can themselves be a source of financial market instability. So you get some maybe yield back up and there's a liquidation of bottoms, and then that causes selling over all of the strategy.

Every time we get one of these sharp down drafts, people point to if they don't point to risk parity, they point to some other systematic strategy in which there's

some mechanicals selling. How much does that concern you? So I think it's a concern because there are certainly more instruments and vehicles ets in disease that are rules based, whereby if there's a shock to the market, there's a sell off and that activates other triggers and let's say quant portfolios, which further sells off, and then that causes an increase in the realized volatility of those asset classes.

So I think it's it's definitely a concern, and it's a concern in more I would say, very specific asset class or areas. So risk priorities an element that's widely discussed because there's so much money invested in risk parity type funds and instruments. I mean, the estimate that I heard the other day is that there's over four billion

in risk parity type solutions. So when all of this money is moving at the same time, given the nature of dynamics, we're seeing these increases in volatility, So we have to think about it from a kind of mark to market daily perspective. It's a concern, but remember why we're doing this in the first place, which waning to achieve outperformance versus let's say the sixty benchmark on average

three time. So if investors a patient and ride out those volatility shocks in certain cases, as long as the portfolio has been set up well, you're still expecting to do better, and so there's more noise, I would say, but that doesn't necessarily change the structural effects, which is why we ultimately we should be positioning our portfolio is based upon our objectives and the structural things we want

to achieve. So basically, I think that as long as we position our portfolios accordingly based upon the objectives we're trying to achieve in the long run, whether that's the investment objective over one year or five years or further then riding out the short term shocks, if you will, will always serve us well rather than playing into the behavioral aspects of markets and also the implementation aspects of

these kind of rule based methodologies. Yeah, I wanted to ask you something related to that point, But we're talking a lot about risk parity, systematic funds, quantitative funds, all that kind of stuff. How adaptable are those investment models and how quickly do they respond to changes in the way the market is behaving, like would would they bear very very quickly adapt rules that they had previously been relying on in order to respond to a new market behavior.

So this space has obviously become super coveted. So systematic strategies in general, there's been a huge growth in the a U M and these types of strategies, both in terms of investors allocating to bank index products as well as you know, fun solutions from masset managers. The reality is the business of our groups, and I'm very much

one of the members of this community. Is that we're constantly looking at how best to do things, how best to manage risk, the sensitivity of the rules or parameters that we're setting. And as such, I would say that in certain cases it's very rapid and reactive, but that may not necessarily be a good thing. So some times you find that, especially on the asset management side, they update the rules or change their parameters quite frequently. But how do they How do we know that? You know,

in essence, when that strategy was designed. It's based upon historical data. So if you see one or two observations of these, yeah, I would say massive changes in the ways that the returns are being delivered, Does that justify changing your parameters based upon all of the analysis that you've done historically over the last thirty or forty years. Again,

it's a question of research. So sometimes I think the industry may try to change things rapidly, but is that the best thing for the actual product, for markets, for investors. And so at least you know, our group Barclays is very concerned and constantly monitoring these things, and we tend to want to design strategies where we're extracting an economic source of return which has been shown to be there in the long run, and we that will be they're

going forward. If there are slight variations and how that return premium is delivered, then either you know, we we need to update our prize on the research, or we need to really believe in what we've done and manage through the risks, and in such cases then we choose not to change those rules or updates. Being dynamic is not necessarily a good thing all the time. Sometimes you need to just realize that there are these short term noise effects that you just need to know right through

if you will. There are some historical sources of return in market that right now people are talking about is having been kind of busted. Whether it's value stacks that haven't done as well, haven't reverted to the mean as people expected, or various trend following or momentum strategies that haven't added much diversification to people's portfolio. So I guess this is exactly what you're saying. When you look at these strategies which are designed to give people sources of diversification.

How do you think about applying the test to determine is this just a very long period that will mean revert or has there been some sort of trend break that will say, yeah, it's time to move on and look for some new sources of alpha. That's a great question, and it's very topical for the alternative risk premier space over the last six to nine months, because in general the space hasn't delivered the returns for the risk that

we're taking that is in line with historical norms. Across the various providers to this space, everyone's being asked the same question. But what's really interesting is when you go back to the data and this is what we use and the economics about how we've designed these strategies. And for instance, and the example of let's say value investing in the cross section of stocks, when you look at

the data, we've been there before. You know, we've we've seen the fact that there are certain periods in certain cases for value or the size effect where it hasn't worked for a period of five, seven, ten years, but then it reverted. So looking in the data, we're not in this case. We're not in this place where we feel there's a structural dislocation in the relationship of the returns being generated versus how people are going about investing in let's say value stocks, and as such we ultimately

need to write through the cycle. These things are cyclical in nature. They're based upon macroeconomics, which as we know, have very long cycle effects, and so I wouldn't say that, you know, we're as worried, but that being said, the other side of the coin. So that's a very general comment, but the other side of the coins that the devil is in the detail. So different implementations will give you

answers of different results. So, for instance, in the in the value space, you know, using the book to market ratio, which was the original factor characteristic motivated by Farmer and French, may provide a different side of the value premium from say the cape ratio, which is something that Professor Schiller obviously advocates for, or even things like let's say total

yield or other factor characteristics. So there are ways to diversify the specific risk associated with choosing one factor characteristic, which is a sensible approach, and I know it's something that various participants will advocate for. I think, you know, as long as we continue to look at doing things from a sensible macroeconomic way where we diversify the way

we access. In this case, you value stocks and the value in the cross section of stocks, then that's the best way for investors to continue to reap the premium, even in a period where perhaps that premium is not as high as it has been historically. All right, well, Farruke, that was really a fascinating conversation and a ton to really think about going forward as we sort of continue to debate whether or not we're seeing a temporary or a sort of lasting shift in the relationship between bonds

and stocks. Brup Savage, head of Investment Strategies Research at Barclay's, Thank you so much, Thank you for joining never much so, Joe. I found that conversation really really topical and fascinating, and you know, I thought we set it up reasonably well in the sense that this is one of the most difficult concepts in all of investing to really think about, and you know, much less to capture or to model

in an effective way. I totally agree, you know how like both of us go on TV and we write articles sometimes and people will be like, Oh, I like cyclical stocks right now, or I like tech stocks right now, or I like emerging markets, and all that's fine and good, But in my dream all conversations and markets would be about portfolio strategy, because it wouldn't. It's it never makes

sense to just go into emerging markets. It only makes sense to think about what weights you want to apply to emerging markets in light of everything else, and give it the various risk profiles. And so that conversation that we just had is sort of the conversation on some

level that I wish all of our discussions were based on. Oh, you're absolutely right, except I think all our TV discussions would end up being about three hours long because first week that's discussed broad portfolio construction, and then we get into individual calls. But you're absolutely right. The context matters, and it's a little bit silly to be talking about should you buy or sell emerging market equities if you don't know what the rest of the portfolio looks like.

The other thing that I was thinking about during that conversation was there's an interesting theme in there about, you know, the short term changes versus these sort of long term fundamentals, and we've been seeing that crop up in the corporate world. Now. It's interesting to hear something vaguely similar when it comes

to investing. Yeah, absolutely, And this idea too that you know, you have to obviously look at the macroeconomic backdrop, but also just the market structure backdrop is another thing that I just don't think we talked about enough right now. It would be as easy as it. I could buy sup SP t F really easily, or I could buy a Japanese government bond E t F really easily. I think one of those exists that was just not a thing that was available to me or to the average

investor several years ago. And it's almost impossible to imagine that that hasn't changed the relationship between two asset classes that may have been once very disparate and represented a source of diversification, and now they're just h you know, the difference is just a ticker symbol on a online brokerage account. Right, You can rebalance your entire portfolio with the click of a button essentially, Yeah, right, And it's

just this these things that we create the relationship. I always think about long term capital management that hedge funds that blew up. They bought a bunch of assets that were seemingly totally diversified and shouldn't have been correlated with each other, but by virtue of the fact that they were the one entity that held them all, they then

became the source of correlation. And everyone knew they owned all these assets, so people have traded against them, and so they they essentially created a correlated managed to create a portfolio of correlated assets from things that without l T c M in the market, would have been uncorrelated. Joe, We're going to have to do another Odd Thoughts series

famous miscalculations of correlation throughout history. So first we're gonna do we have to do our accounting series, because last episode we talked about how we needed an accounting series, and now we need a whole another series on a portfolio structure. I'm into it. God, Okay, al right, Well let's call it a day then, because it seems like we're going to have a lot of work to do in the future. This has been another episode of the

Odd Loots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe wisn't All. You can follow me on Twitter at the Stalwart and you can follow our producer on Twitter tofur Foreheads. His handle is at Foreheads t and you should follow the Bloomberg head of podcast, Francesca Levi on Twitter at Francesca Today. Thanks for listening a