Based on this, we advise all investors to form a “balanced” portfolio, in which the distribution between stocks and bonds fluctuates around 50/50. Today, this fundamental position no longer withstands any criticism.
For nearly 30 years since 1966, the correlation between stocks and bonds drifted into the negative, according to BCA Research of Montreal, helping to create modern portfolio theory. This negative correlation also prevailed throughout most of the 20th century. When the stocks in the portfolio fell, the bonds kept it afloat, and vice versa.
However, since 1997, the correlation between the two asset classes has steadily increased, and today the two classes often move in tandem. Worse, bonds offer negative yields that fall as stock prices fall.
This idea of a stock-to-bond ratio is the lure, said Judge Janick Desnoyers, vice president and chief economist at Addenda Capital in Montreal. “The correlation between stocks and bonds is a random event that only at a very superficial level characterizes the evolution of prices for these two assets. The financial community talks about correlation, but economists talk more about causation. »
In fact, the economist explains, the two categories of assets are subject to very different economic imperatives, so sometimes they can be correlated and sometimes not. There is no ironclad rule that stocks and bonds must move in different directions. When economic and financial conditions require it, their ratio increases, as is the case at the present time very sharply; and when conditions dictate otherwise, their correlation decreases.
Thus, Yannick Desnoyers distinguishes three variables that determine the “correlated” or “uncorrelated” relationship between stocks and bonds: an acceleration or deceleration of the economy, an increase or decrease in inflation, an increase or decrease in central bank key rates. “The correlation depends on the economic context,” says the economist. That is why many have been caught since the beginning of the year. »
For example, in the event of an economic slowdown and rising inflation, the “correlation” will increase; however, if the economy picks up and inflation falls, the “correlation” will weaken. It all comes down to how inflation and the economic downturn increase expectations of a decline in the future value of earnings and affect asset prices.
“Without inflation, and even in the event of a recession, a classic 60/40 portfolio will win,” explains Janick Desnoyers. Stocks are falling, but bonds are doing well: the correlation is weak. Add in inflation and we’ll see both assets fall: the correlation is inverse. »
The third variable, the key rate of central banks, is designed to change the current strong “correlation”. “It may take a little longer,” the economist said. However, this will change with a recession when key rates are high enough to curb inflation. At this time, the central bank will lower its rates, which will improve bond yields, which will offset losses in the stock market. »
Thus, Janick Desnoyers expects the key rate of the US Federal Reserve to reach 4.5%. The time will come to return to the bond market shortly before the key rate reaches this cyclical peak.