Market Insight - A turbulent relationship for the equities/bonds couple by Marco Bonaviri

Since the beginning of the year, US 10-year Treasury yields have increased from 2.4% to 3.1%, driving the year-to-date return in these bonds- which have been considered a safe asset for over 30 years now- beyond -4%. Furthermore, during Q1 2018, for only the fifth time in 20 years and the first time in almost 10 years, US sovereign bonds fell in tandem with equities by more than 1%. More generally, the number of downturns in equities and bonds occurring simultaneously among developed markets has trended higher lately. Are we at the dawn of a change in paradigm in the relationship between equities and bonds, which could have major implications for multi-asset class portfolios - also known as “balanced” portfolios?

Asset allocation, i.e. the proportion allocated to each asset class, is the very essence of the dilemma facing most investors. It also represents the core business of wealth managers. The objective of the allocation process is to achieve a level of diversification which enables a reduction in portfolio risk and optimises risk-adjusted returns. However, the benefits provided by diversification depend on the relationship between asset classes, gauged notably by the statistical concept of correlation, which determines the direction and strength of the relationship between two variables. The viability of the portfolio construction process therefore draws heavily on the correlation between equities and bonds, which are the two major components in balanced portfolios. Ideally, this correlation would be negative, enabling bonds to partially offset equity drawdowns and reduce portfolio volatility. Meanwhile, the negative contribution from bonds to portfolio returns during bullish equities/bearish bonds phases should remain marginal.

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