As markets shift focus to recession from inflation and interest rates, the positive correlation between equities and bonds will reverse, according to Colin Dryburgh, multi-asset investment manager at Aegon Asset Management.
“As global economic concerns shift from high inflation to weak growth or recession then the case for central banks continuing to tighten monetary policy will abate, he says. “This should be supportive for longer-term government bonds and other high-quality fixed income instruments.
He adds, “The correlation between bonds and equities typically declines as economic growth deteriorates. For example, as the US economy approached recession in both 2002 and 2009 the equity bond correlation flipped from positive to negative.”
Dryburgh’s views are shared by other market participants. For example, senior markets economists at Capital Economics, also noted that the bonds and equities may be returning to their usual relationship.
They said that monthly returns from US stocks and 10-year Treasury bonds were often negatively correlated over the past two decades, with 2022’s strong positive correlation being unusual.
Last year, saw the S&P 500 slide over 20% while yields on 10 year US treasuries climbed to 2.5%. In the UK, the FTSE100 dropped by 4.5% while the yield for 10-year gilts was almost 2.4%.
Valuations have already adjusted in equity markets, according to Dryburgh, taking them closer to the long-term average. This should, he says, give equity investors less of a headache this year, although he believes the chance of recession in western economies is currently a close call.
He adds, “It is a close call whether western economies avoid recession this year. The US yield curve is currently inverted, and this typically precedes a recession. Should a recession occur then corporate profits will decline, and risk asset prices will likely face further downward pressure.”
He notes though that many of the factors that drove inflation higher have abated or reversed, with Covid-related production constraints and supply chain bottlenecks easing. Also, a two-year surge in most commodity prices has ended, despite Russia’s ongoing war in Ukraine.
