Stocks and bonds are falling simultaneously. Should you be concerned?

Equities and bonds have become more correlated as inflation expectations become unanchored. This can be challenging for investor’s portfolio in a market downtrend.

We are not overly concerned as we see a lower likelihood of a further simultaneous decline, as both equities and bonds typically rebound quickly.

Staying active is vital to defend the portfolio’s return during market turmoil. For our MAPS portfolios, we have actively maintained our diversification choices, rebalanced periodically, all while remaining focused on the longer-term horizon and the right asset classes during this period of market volatility.

Despite the positive equity-bonds correlation, we see the merits in bonds as they enhance our portfolio diversification and dampen equity market drawdowns.

2022 has been challenging for global investors. If the market in 2021 was one of strength, then the market in 2022 can be described as one of caution and volatility. Major asset classes sold off dramatically as mounting inflation concerns and recession fears brought about a collapse in global risk sentiment. Global equities and bonds fell by 14% and 18% (in SGD terms) respectively in the first six months, with most regions delivering negative returns in the same period (Chart 1).

Beneath the hood, the one and three-year correlation between global equities and bonds have also increased since the start of the year, implying that both asset classes are more tightly correlated (Chart 2). This generally happens when inflation expectations become unanchored as consumer price inflation (CPI) readings exceed policymakers’ target (Chart 3). While a positive equities-bonds correlation is not uncommon, being correlated during a market downtrend implies that bonds have become a less effective hedge for equities. This phenomenon can have implications on an equities-bonds portfolio, such as our FSM Managed Portfolios (MAPS portfolios).

In this article, we address the above concern and share the reasons why investors should stay active during this period. We also share the recent portfolio actions – which we deployed - to help combat the volatility.

Chart 1: Performances for major equity and bond segments have been poor year-to-date

Chart 2: Global equities-bonds correlation, which has turned positive, continue to rise in the year-to-date

Chart 3: Rising inflation can explain the recent rise in equities-bonds correlation

Equities and bonds falling together is not a common occurrence

Empirical data over the past three decades suggest that it is relatively uncommon for equities and bonds to decline in tandem. Over the past 30 years, since 1990, there were only 76 out of 388 months in which both asset classes (gauged by the MSCI AC World Index and the Bloomberg-Barclays Global Aggregate Bond index) fell together - around 20% of the time. On a quarterly basis, in the same period, there were only 19 out of 128 quarters in which both asset classes fell together - around 15% of the time.

Our observation further suggests that this tends to happen during (A) periods when market participants expect an economic slowdown or a recession, or (B) when inflation rises and policy rates are expected to increase. Outside of these situations, it is relatively rare for equities and bonds to decline in tandem. As markets increasingly price in (A) and (B), with a significant decline in equities and bonds over the last few months, we see lower likelihood of a further simultaneous decline - as supported by our observations in the following section.

Equities and bonds tend to rebound shortly after

Based on our observation, consecutive months of negative returns for both stocks and bonds are rare. Only around 3% of the time (10 out of 388 observations), both stocks and bonds fell for more than a month. Consecutive months of negative returns tend to occur when the price decline for equities and bonds is mild in the first month, suggesting that markets have yet to fully price in (A) and (B), thus increasing the likelihood of multi-month decline in equities and bonds.

For example, back in 2018, US inflation surprised higher in May and June with headline CPI of 2.5% and 2.8% year-on-year respectively. Global growth has also started to moderate as tariffs from the trade war began to exert its toll. Consequently, equities and bonds fell marginally in May (-0.2% and -0.8% respectively) and continued the decline in June as markets continued to price in (A) and (B). This is in contrast to what we have observed in this year so far, where equities and bonds have already declined dramatically (-8.1% and -5.5% in April alone), likely pricing in both scenarios.

We also observed that both equities and bonds tend to rebound soon after their simultaneous decline. As shown on the chart, equities and fixed income rebounded by an average of 1% just three months after, and around 6-7% 12 months after. This should abate concerns for investors with horizons beyond the near term.

Chart 4: Equities and bonds rebound soon after declining together

Stay active during the turbulence

We believe staying active is vital to defend the portfolio’s return during market turbulence. The following are some of the portfolio actions that we have deployed to actively reduce downside risk in our MAPS portfolios.

i) Diversification to reduce the asset correlation and prevent major downside risk

Diversification is an important tool to reduce portfolio correlation and minimise exposure to downside risk. During this market turbulence, we have actively maintained our diversified exposure across asset classes, regions, and segments for MAPS portfolios. Two reasons anchor this decision.

First, we aim to invest in assets that have little or no correlation to one another as this can prevent major losses. This is particularly beneficial in a downward-moving market as a portfolio with assets that are less correlated can not only reduce the overall volatility but also reduces the risk of sharp drawdowns. On the contrary, investing in assets that are highly correlated during a market downtrend can result in larger downside risk.

Second, investing in assets that have little or no correlation minimises our portfolios’ exposure to localised risks. In our view, many of today’s headwinds are macro and event risks such as the Russia-Ukraine war, aggressive central banks, and economic growth concerns. A majority of them are either localised or more severe in one country/region over the others. This makes diversification even more effective in reducing the exposure to such risks.

While the correlation between equities and bonds have turned positive this year, major bond segments still demonstrate a lower correlation to major equities regions, denoted by the blue and dark blue highlights as seen from Table 1. This implies that holding a portfolio of equities and bonds provide more effective diversification than a single asset class portfolio. Despite the positive equity-bonds correlation, bonds still enhance portfolio diversification in the longer term and are income-generating assets that not only provide yield, but are also able to dampen equity market drawdowns.

Table 1: Equities-bonds correlation matrix, 1-year and 3-year correlation

Source: Bloomberg Finance L.P, iFAST compilations.

Data as of Jun 22. *Correlation using weekly returns in local currency terms.

ii) Disciplined rebalancing strategy works well when markets are choppy

Rebalancing works well in today’s volatile and choppy market. During periods of wild market volatility, asset allocation can drift notably from the intended target allocation, leaving the portfolio more exposed to downside risk. For our portfolios, we adopt both periodic and range-based rebalancing, which is rebalancing being triggered when the asset allocation is outside a pre-specified range. We regularly utilise both to enhance our return profile and maintain our diversification choices during this period of market volatility.

Rebalancing the portfolio enables us to maintain our diversification choices through the volatile market. By rebalancing, we are actively resetting the portfolios to the intended diversified allocation. This can also produce a more stable portfolio during volatile periods, instead of one which mirrors the market. By rebalancing, investors are also buying into assets that have underperformed (by selling those that outperformed). This ensures the portfolio is well-positioned to participate in the eventual recovery of the underperforming asset.

To illustrate the positive impact of rebalancing on portfolio performance, we backtested a buy and hold (no rebalancing) and periodic rebalancing strategy (quarterly, semi-annually, and annually) for a 60-40 global equities-bonds portfolio. The results suggest that periodic rebalancing produces 5-10% higher return than buying and holding a 60-40 portfolio over a 20-year period, even after factoring in the transaction costs (Chart 5). The longer the portfolio’s investment horizon, the larger the performance differences between the strategies.

Chart 5: Periodic rebalancing produces 5-10% higher returns (for a 60-40 portfolio) than not rebalancing over the long term

iii) Focus on the long term horizon and the right asset class

During a market downtrend and periods of volatility, it is important for investors to look beyond the near-term and select assets that are able to deliver attractive returns over the long term. Investors may be tempted to withdraw all asset exposure and re-allocate to cash during market turbulence, as cash may tactically outperform other asset classes in the near term when markets are volatile given its resiliency to capital destruction. However, cash severely underperforms other asset classes over the long term. Besides, equities and bonds have already corrected significantly – the US equity market is already in bear market territory – and investors who cash out now will realise significant losses.

As illustrated in Chart 6, throughout a period of 5, 10, and 20 years, cash tends to deliver subpar annualised nominal returns as compared to equities, bonds, and a 60-40 equities-bonds portfolio. On a real basis, taking into account of inflation, cash also delivers subpar long-term return, compromised by its inability to generate strong capital gains to offset inflation.

For MAPS portfolios, our team maintains a long-term horizon and believes our equity-bond allocations can provide resiliency without compromising long-term returns. Our equity allocation can help to achieve stronger portfolio returns in the long run, albeit with higher volatility. Our bond allocation, on the other hand, aims to reduce the risk of large capital losses in the near term and stabilise the portfolio.

Chart 6: Cash tends to deliver subpar annualised returns over the long term

Be prepared for the road ahead

In summary, today’s market environment remains challenging but staying active to manage risks can help to improve and defend portfolio returns. For our MAPS portfolios, we have actively maintained our diversification choices, rebalanced periodically, all while remaining focus on the longer-term horizon and the right asset classes during this period of market volatility.

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Stocks and bonds are falling simultaneously. Should you be concerned?

Chart 1: Performances for major equity and bond segments have been poor year-to-date

Chart 2: Global equities-bonds correlation, which has turned positive, continue to rise in the year-to-date

Chart 3: Rising inflation can explain the recent rise in equities-bonds correlation

Equities and bonds falling together is not a common occurrence

Equities and bonds tend to rebound shortly after

Chart 4: Equities and bonds rebound soon after declining together

Stay active during the turbulence

i) Diversification to reduce the asset correlation and prevent major downside risk

Table 1: Equities-bonds correlation matrix, 1-year and 3-year correlation

Data as of Jun 22. *Correlation using weekly returns in local currency terms.

ii) Disciplined rebalancing strategy works well when markets are choppy

Chart 5: Periodic rebalancing produces 5-10% higher returns (for a 60-40 portfolio) than not rebalancing over the long term

iii) Focus on the long term horizon and the right asset class

Chart 6: Cash tends to deliver subpar annualised returns over the long term

Be prepared for the road ahead

The Research Team is part of iFAST Financial Pte Ltd.

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