Negative Stock-Bond Correlation Won't Last Forever

PGIM, Prudential Financial’s asset management arm, put out a white paper recently that examines the role of stock-bond correlation in institutional portfolio construction. The study also looks at the historic context of this correlation, and suggests scenarios for investors to consider if the correlation regime should shift.

Stocks and bonds have been negatively correlated for the past 20 years, acting as a reliable hedge for each other, according to PGIM. This correlation has helped to lower portfolio volatility without reducing allocations to stocks. 

However, in the preceding 30 years, from the late 1960s to the late 1990s, the correlation was reliably positive.

What factors lead to a regime shift? PGIM found that a regime change is driven, in part, by changes in the macroeconomic and policy backdrop.

Based on 70 years of U.S. history, the sign of stock-bond correlation regimes rests on three macroeconomic pillars: fiscal policy sustainability; monetary policy independence, credibility and predictability; and the balance between demand and supply-side economic drivers.

According to PGIM, sustainable fiscal policy, independent and rules-based monetary policy and demand-side shifts tend to support negative stock-bond correlation. Unsustainable fiscal policy, discretionary monetary policy, monetary-fiscal policy coordination and supply shifts tend to support positive correlation.

The study found that stock-bond correlation is reliably associated with interest rate volatility, the co-movement of economic growth and interest rates and the co-movement of equity and bond risk premia.

PGIM calls these economic conditions “symptoms” of the underlying macro environment, which at the end of the day relates to monetary and fiscal policy and broad economic shifts.

If a shift to positive correlation should occur but all other factors remain equal, chief investment officers will face a tradeoff between maintaining existing risk targets, reducing their stock allocation and lowering expected returns, versus maintaining existing return targets and accepting higher volatility and lower risk-reward characteristics — though in history all else is rarely equal, PGIM says.

The study says chief investment officers should be attuned to macroeconomic policy shifts that may signal a change in regime. 

It notes that continued low interest rates by themselves may be insufficient to support the current negative stock-bond correlation. Depending on the macroeconomic policy environment, low interest rate scenarios with positive stock-bond correlation may emerge. 

CIOs with strong macroeconomic policy views may want to use the study’s findings to translate those views into an expectation for stock-bond correlation, according to the study. For those without strong views, PGIM advocates a zero correlation expectation, which it says will produce a prudent risk assessment.