Over the last 12 years, this has been particularly evident, as we’ve seen a significant inverse correlation between equity returns and 10-year Treasury returns. The effect has been abundant beta with lower portfolio risk. The fundamental benefit of negative correlation over the last 20 years has been that as equities fall, bonds rise, providing smoothed returns and hence lower risk. This relationship has begun to sharply reverse, precipitated by significantly higher inflation and high equity valuations being vulnerable. 

To hear Paul's thoughts, watch the interview below:

The environment since the GFC has been marked by looser monetary policy than would otherwise be prescribed under a rules-based approach, such as Taylor’s Rule. This was also the case through the 1960s, which as we know led to significant inflation through the 1970s.

What is central to assessing the future equity-bond correlation is the degree to which monetary policy is counter-cyclical or pro-cyclical, and this depends on whether inflation can be moderated. The table below shows some possible scenarios:

The key difference in each of the scenarios is the degree by which central banks act to manage inflation to a rules base, primarily Taylor’s Rule.

Scenario 1 infers continuing issues with supply and bottlenecks, COVID, zero tolerance in China and governments accepting higher inflation to inflate away their nominal debt. In this situation, we see a return to positive correlation and rising risk premia for equities and bonds.

In scenario 2, which is arguably where western central banks see, or hope, they’re operating, supply issues start to resolve themselves (particularly in China) but labour remains tight and wages elevated. Central banks continue to raise interest rates and this restores price stability. This would likely see a return to a negative equity-bond correlation.

Scenario 3 is a weaker version of scenario 2 in that the supply chain pressures take longer to resolve themselves, and in response, central banks tighten liquidity.

Our view is that central banks currently have the vindication of scenario 2, but fiscal and monetary policy paths are less clear or certain than what they were pre-COVID. For investors, the primary consideration is that market beta has been generous to them over the last 12 years, with accompanying lower volatility. Now investors have to be prepared to generate reasonable returns out of alpha (return from individual investments, independent of the market) with higher volatility. Market beta has been like a free lunch, and we know that there is rarely, if ever, a free lunch…