Positive Stock-Bond Returns Correlation for the First Time in 30 Years, and Why it Matters

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IN THIS PUBLICATION:

• Equities now look the least attractive versus bonds since the end of the GFC in 2009.
• The rally in Europe is overdone, and we wouldn’t be chasing upside at these levels.
• Last year, the trailing 3Y correlation between stock and bond returns turned positive for the first time since November 2000. We explain why this matters, a lot.

Context

• Investors have been delaying their expectations about the timing of the first interest rate cut (i.e., pivot). It now looks like it may not happen until 2024.
• In fact, since the beginning of 2023, 5-Year US Inflation breakeven rate (which highlights general expectations about where inflation will be in 5 years' time) has started moving higher once again after peaking in March 2022.

• The market now seems to expect higher inflation for longer when compared to the beginning of the year. This is a bearish outlook for asset prices, and the bond market has been pricing that in for a while now, ahead of equity markets (that’s usually the case – bond markets react faster than equities).
• In fact, when considering proxys for Equity Risk Premium (which represents the excess return you’re being paid to invest in equities rather than bonds), equities now look the least attractive versus bonds since the end of the GFC in 2009.

It kind of feels like macro investors are currently divided into four camps:

• The ‘no landing’ camp, who believe the worst is behind us and it’s mostly a rosy outlook from here based on excess savings, strong labour market, and fiscal stimulus.
• The soft-landing camp, who trust the Fed will correctly calibrate how far they can hike and for how long.
• The “asset deflation” bear market camp, who expect multi-year negative performing markets, intermittently interrupted by violent short-squeezes, like we saw last year and in the early 2000s.
• The hard landing camp, who expect that a capitulation event is still ahead of us.

Choose your team wisely.

China’s Reopening

• On the positive side, the Purchasing Managers Index (PMI), an indicator that serves as proxy for industrial activity, came in at the highest level since 2012, leading to a rally in Chinese equities after they’d begun rolling over in mid-January. Travel seems to be back, albeit shy of what 2019 looked like.

• Chinese power demand is up, and they’re now once again importing coal from Australia (which highlights openness to trade). It seems that we’re closer to being back to business as usual… but recent headlines make it harder for me to be risk on.
• Lending has mostly gone to corporates and not households (which should have a negative impact on consumption). We’ve seen the Chinese Ministry of Finance issuing informal guidance to state-owned corporations to let contracts expire with the Big Four accounting firms (surely that doesn’t add to investor confidence). On top of that, you have investors like Mark Mobius complaining about his inability to take money out of China. And lastly, more than half of all local governments are in breach of debt thresholds – which, as Bobby Vedral says, may limit their fiscal spending capacity.
• In our Ask Me Anything (which I forgot to record so it’s now forever lost, but make sure you tune in for the next one), I asked Jacob how he feels about the reopening, and whilst he acknowledges the risks, he thinks that, from a geopolitical POV, China’s firing cylinders as it was in 2012 (when they were at peak production), and when that happens, we shouldn’t miss the forest for the trees.
• Since our January report, he’s now slightly more risk on due to China (this bullishness is partially offset by the growing uncertainty from the Russia-Ukraine war, which we last updated in our most recent Geopolitical Update).

Europe’s Divergence

• Economic data is rolling over in Europe. Real wages in Germany are painting a tough reality after having registered the sharpest drop in 15 years. Across the EU, inflation is still pretty high, and investors now expect the ECB to only stop hiking when rates hit 4% (vs 3.5% previously).
• Despite that, the DAX and CAC are at all-time highs, the FTSEMIB is at a post GFC high, and Greece is not too far away from that either. Go figure.

• Just look at the outperformance of European banks vs US banks… My two cents is that the rally in Europe is overdone / not really sustainable and that I wouldn’t be chasing upside at these levels.

Stock-Bond Correlations

I’ve been a fan of Dan Rasmussen (and Verdad’s) work for quite a while now, especially given (1) how technical their research is, allowing me to plagiarize their work to sound smarter than I actually am, and (2) how generous they are in putting it out for free. Last week, they highlighted a phenomenon that I believe is of the utmost importance:

“For the past 30 years, the correlation between stocks and bonds has been negative. But last year, the trailing three-year correlation turned positive for the first time since November 2000. This is something that many investors today have never experienced in their professional lives.”

Understanding the drivers of changes in this correlation and its implications matters quite a bit given that the 60/40 portfolio (60% allocation to equities and 40% allocation to bonds, with the key idea behind it being, as most of you probably know, that losses in the equities portion of your portfolio would be offset by gains on the bond side, and vice-versa) is the starting point of many asset allocation strategies that are implemented around the world.