Manulife CIO weighs in on the question of if positive equity-bond correlations have become structural
Once again, bonds’ supposed safeguard against equity downturns has failed to materialize. Long-duration US Treasury bonds, the lynchpin of fixed income portfolios for millions, have flagged and struggled alongside equity markets since the outbreak of the US-Israeli war with Iran. That’s happened, in large part, for event-specific reasons. A shock to energy supplies is inflationary, causing bond markets to revise the likelihood of Fed cuts this year. A war is expensive, further exacerbating existing problems with US fiscal spending. There are specific reasons why treasuries aren’t holding up as they should, but we are seeing more of these moments of positive correlation.
Nathan Thooft is seeing these incidents firsthand. The Chief Investment Officer, equity & multi asset solutions, and Senior Portfolio Manager at Manulife Investment Management notes that a range of factors since the COVID-19 pandemic have conspired to create these moments of positive correlation. As the risk of bonds and equities falling together grows, he weighed in on the question of safe havens and where advisors can go to protect their clients’ portfolios now.
“From a historical perspective, the only real safe havens this go around have been cash, exposure to energy related securities or physical oil, and the US dollar. So there hasn't been a lot of safe havens. And one of the challenges with that is that for the handful of safe havens that are working, they're working really well because the rest of them aren't,” Thooft says. “The question then is why haven’t treasuries [worked], and one of the reasons is that we’re in an environment where there’s already skittishness around fiscal spending and the potential for inflation to be sticky, and this particular conflict exacerbates both of those fears.”
The increasing frequency of shocks that cause stocks and long-term bonds to demonstrate positive correlation is, in in Thooft’s view, on the way to becoming structural. Those long-term bonds’ utility as portfolio diversifies, therefore, is worth reconsidering. He notes that there are still recent risk-off moments where treasuries have done what they should, but the macro environment has shifted significantly and now contributes more frequently to those positive correlations.
That begins, in Thooft’s view, with the textbook example of 2022 when high inflation brought stocks and bonds down in line. He notes that before 2022 the world had a massively underpriced term premium, which has only just begun to get repriced on bond markets. Inflation has also remained stickier, though not at 2022 levels, and has shown more periods of volatility. There is also a huge amount of fiscal spending by developed nations, and while the US has been often talked about, it’s hardly the only culprit.
While high fiscal debts are a problem for bond markets, Thooft also cautions against apocalyptic thinking regarding those debt levels. The majority of the developed world is running up high debts, he notes, and countless past moments have been characterized by similar hand-wringing about public debt without major event.
Thooft also notes that Japanese negative interest rates and zero inflation for almost three decades was globally suppressive for interest rates. As Japan has started to normalize and experience some inflation of its own, its yield curve has moved up and its longer-dated bonds no longer serve as the floor for global rates.
For advisors and investors, this macro picture raises the question of where they can find long-term safe havens if US 10-year treasury bonds can’t be relied on. Gold had clearly become a haven of some preference, but it has notably pulled back in this recent shock, in part because of how far it had run in the leadup. Thooft notes that at times certain cryptocurrencies, commodities, and private assets have all demonstrated those safe-haven qualities and seen capital flock to them. Thooft notes that there may be some structural demand dynamics in many alternative diversifiers, tied to concerns about repricing term premium for longer-end bonds.
The solution, from Thooft’s perspective, is to seek a diversified basket of diversifiers. He still sees treasuries working at times, and shows a preference for medium-term bonds in the so-called “belly” of the yield curve. Those bonds offer a little bit of spread, a little bit of incremental yield, and some of the traditional diversification benefits of a bond allocation. Cash works as a parking lot in the short-term, and US dollars can help diversify. So can alternative assets, commodities, and other assets that show different relationships to broad market sentiment. He adds that even long-duration fixed income can still work from time to time. The traditional 60/40 portfolio, he says, is not fundamentally unworkable but it can use a rethink. It’s for advisors to use this moment to determine what might be right for their clients.
“The concept of balanced strategy isn't broken, but it can be enhanced through other diversifiers. And that's the messaging we're trying to get out there and us as well as many other firms are focused on,” Thooft says. “What are those alternative diversifiers that you can complement a traditional 60/40 portfolio with? Those are the tools that you can build a more holistic, well-rounded, all-weather approach to a balanced portfolio by having those additional instruments.”
