In a holiday-shortened week, domestic stocks tacked on modest gains, though most remain negative for the month. Absent substantial increases over the next three days, the S&P’s streak of consecutive positive months will end at 15 months in February – a remarkable run. Global stocks indices were mixed last week. The Nikkei’s decline of 1.1% dragged on the broader international Europe Australasia Far East (EAFE) Index (which fell 0.8%), even as European stocks rose by 0.3%. China’s 2.6% gain was the standout regional performer, yet the country’s leading index remains down nearly 5% month-to-date. Fixed income yields were volatile as the 10-year US Treasury yield rose to 2.95% intra-day on Wednesday, before settling at 2.87% (a decline of 0.1% from the previous week’s close). Precious metals declined (gold -1.4%, silver -0.7%), while prices of energy commodities increased with WTI Crude rising 3.8% to $67.29 per barrel.
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Inflation and Stock/Bond Correlations: It is often considered an investment axiom that stocks and bonds are uncorrelated and therefore a portfolio that includes each will be well diversified. While it is fair to say that over long periods of time stocks and bonds tend to have a low correlation to one another, a closer examination of historical data reveals that the correlation relationship is unstable. That is to say, there are periods when bonds are a less effective diversifier to equities than in other times.
The correlation between the two tends to be lowest during periods when deflation is of more concern than inflation. Conversely, when inflation becomes of more significant interest, stocks and bonds prices tend to have a higher correlation. The chart below highlights the changing dynamic of stock and bond correlation.
Source: Bianco Research, L.L.C.
In this chart, the rolling 5-year correlation of stock and bond prices is lowest from 1954 to 1966 and, more recently, since 2001. The recent period is most straightforward to remember, which includes the Financial Crisis and the Fed’s aggressive response to stave off a deflationary economic cycle. True to form, both of these periods of deflationary concerns were accompanied by low (and even negative) stock/bond correlation. Conversely, the shaded region of the chart from 1966 to 2001 was a period when inflation was a primary concern for financial markets. During this period, the correlation of stocks/bonds was positive, and as a result, the diversification benefits of bonds were of lower value.
The changing relationship (“non-stationary” to use a technical term) between bond and stock prices in different market regimes is important. This is especially true at inflection points when market concerns shift from one regime to another. At present, the market appears to be transitioning from a deflationary regime to one that is more concerned with inflation. For example, the chart below shows the 15-day percentage change of the total return of the S&P 500 (x-axis) and the total return of the 10-year (y-axis). The red circles on the chart highlight how unusual the trading has been since the stock market peaked on January 26, 2018. According to Bianco Research, “…stocks and bonds have not declined in unison like this since the dysfunctional days of the global financial crisis in late 2008.”
Source: Bianco Research, L.L.C.
Many factors are contributing to a change in investor sentiment regarding inflation, including stronger global growth and very low unemployment levels in the U.S. Moreover, as the chart below highlights, inflation is finally picking up in the Developed Markets. After an extended period of average year-over-year inflation of less than 1% in Developed Markets, it is now approaching 2%.
Source: JP Morgan
Keep in mind I’m not suggesting we are on the cusp of a hyperinflationary environment. Rapid inflation is not the requirement for bonds and stock prices to become more correlated. My point is that if the market has transitioned from a deflationary mindset to an inflationary one, investors who rely solely on fixed income and equities in their portfolios can expect a more volatile period ahead.