Ask a manager of a multi-asset portfolio: What important statistic gets too easily overlooked? The answer will likely be: the correlation between stocks and bonds.
This one statistic provides a breadth of information about the value of diversification at any point in time.
However, it is difficult to forecast. As with returns, historical information is the only guide. Keep in mind, though, that for the purposes of risk management and portfolio construction, yesterday may be largely irrelevant.
A tale of two periods Over the past 15 years, we have enjoyed a period in which the price correlation between stocks and bonds has mostly been quite negative. Simply put, when one zigs, the other zags.
In contrast, however, during the 20 years prior to 2000 — during the equity bull markets of the 1980s and 1990s — this correlation was mostly positive.
Why correlations changed There are a number of theories as to why the relationship changed, but most have focused on the risk of inflation in the 1980–2000 period and the risk of deflation in the post-2000 period.
The question now is, will stock-bond correlation in the coming years return to the level of the 1980s and 1990s, or remain like 2000–2015, and warrant a bond allocation?
The Fed may be a menace Today, many point to the Fed’s outlook for raising interest rates in coming years and anticipate that it will cause strongly negative returns for bonds of all kinds. In addition, as the Fed's confidence grows that we are moving back toward its inflation target, the correlation between stocks and bonds could again become sustainably positive, taking away the diversification benefit.
Bonds matter to diversification We have a different view. We do not anticipate negative results for bonds or the loss of the diversification benefit any time soon.
Across the bond market, we continue to find pockets of opportunity that we think can persist for a while longer. Both prepayment and credit risk of all kinds still appear somewhat attractive. And if the next tightening cycle plays out at all like the last one in 2004–2006, longer-dated bonds could still provide some ballast to riskier assets in portfolios. We find positive carry, measured simply by the slope of the yield curve, to be strongly associated with positive excess returns to duration exposure.
Weighing the risks of inflation and deflation At the same time, we doubt that the world has moved far enough away from deflation to warrant a shift back to a positive correlation between stocks and bonds.
Also, while we have concerns about wage inflation in the United States, inflation trends are influenced by the global setting. There is plenty of excess labor and manufacturing capacity around the world that can help restrain inflation. In addition, the tremendous amount of debt globally provides a deflationary force. The result is that bonds continue to help diversify multi-asset portfolios and bring overall volatility down.
For informational purposes only. Not an investment recommendation.
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
Putnam Retail Management.