investment viewpoints

Equity-bond correlations: was 2022 an outlier?

Equity-bond correlations: was 2022 an outlier?
Alexis Maubourguet - 1798 ADAPT Lead Portfolio Manager

Alexis Maubourguet

1798 ADAPT Lead Portfolio Manager
Clément Mary-Dauphin - Client Portfolio Specialist

Clément Mary-Dauphin

Client Portfolio Specialist

Should we be shocked? Negative equity and bond returns in 2022 provided further evidence that annual performance by the asset classes is not as uncorrelated as commonly believed. How frequently do these so-called ‘outlier’ years occur, and how can investors with long-beta portfolios be better prepared?

 

Need to know

  • We challenge two common beliefs: that equity and bond returns are often negatively correlated and long-beta portfolios with exposure to both show strong risk management
  • On a daily basis, equity and bond returns are often negatively correlated. But in more than two of every three years since the 1980s, annual returns have moved in the same direction
  • On a real-return basis, equities and bonds delivered negative total returns in 15 of the 95 years since 1928, including last year. How can investors better prepare for the not-so-unlikely experience of falling stock and bond markets?

 

An exceptional year?

For passive investors, 2022 was a difficult year. Both equity and bond markets delivered negative total returns: a scenario often categorised as the exception to the norm. The nominal returns shown in figure 1 illustrate this presumed abnormality.

 

FIG 1. Equities and bonds: annual nominal and real returns, 1928-2022

1798 ADAPT Equity-Bond correlation-01.svg

Source: Bloomberg LOIM as at December 2022. Number of yearly occurrence in each quadrant.

 

Analyses like this are often used to conclude that 2022 was an outlier year for two reasons:

  1. The correlation between fixed income and equity returns was positive, while conventional knowledge assumes it should be negative
  2. Long-beta portfolios with considerable bond and equity holdings rarely lose money because having exposure to both asset classes is key to robust risk management

Both conclusions need further investigation, in our opinion.

 

Challenging convention

To begin, let’s challenge the first conclusion: that fixed income and equity returns are persistently negatively correlated. The belief that holding bonds and stocks in a portfolio creates real diversification is the cornerstone of traditional asset allocation and its posterchild, the 60/40 portfolio.

The daily returns of bonds and equities often show a negative correlation. However, plotting annual returns proves that anything but a negative correlation exists between the asset classes, as shown in Figure 1. When making investment decisions it is critical to measure correlations on both a high-frequency (such as daily) and low-frequency (such as annually) basis. Because most investors and asset allocators have an investment horizon closer to one year than one day, we argue that the latter metric is far more relevant to proper portfolio construction and risk management. 

Furthermore, since the 1980s, equities and bonds have moved in the same direction (up or down) in more than two of every three years. Notably, investors voiced fewer concerns about the asset classes being positively correlated during risk-on moves.

To address the second conclusion, we allow that 2022 looks like a rare occurrence according to figure 1. In fact, of the 95 years of history we sample, only five – including 2022 – show bonds and equities delivering negative returns. However, if we look at real (inflation-adjusted) returns instead of nominal, we observe 15 years in which bonds and equities delivered negative total returns (see the real returns shown in figure 1). This implies a 15.8% probability that bonds and equity will both decline in the same year.

Was 2022 an outlier? It was not exactly a tail event.

 

True diversification is not so simple

We do not dispute the fact that 2022 was a particularly challenging year for beta, and inflation-adjusted returns paint an even bleaker picture. But we do make the following assertions:

1. Assuming a solid and permanent negative correlation between bonds and equities is treacherous

2. Any year in which bonds and equities deliver negative real returns in the same year is not an outlier, tail or black swan event. It might not occur regularly, but should not be completely unexpected

With that in mind, we reiterate our conviction in investment solutions that provide genuine diversification. We believe that niche strategies which can deliver alpha with almost zero correlation to the market play an important role in an asset allocator’s risk-management and portfolio-construction strategies. They include hedge-fund strategies exhibiting no directional bias, such as multi-strategy, quantitative, macro and relative-value solutions.

important information.

For professional investor use only
This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name. This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
Any benchmarks/indices cited herein are provided for information purposes only. No benchmark/index is directly comparable to the investment objectives, strategy or universe of a fund. The performance of a benchmark shall not be indicative of past or future performance of any fund. It should not be assumed that the relevant fund will invest in any specific securities that comprise any index, nor should it be understood to mean that there is a correlation between such fund’s returns and any index returns.
Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term “United States Person” shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited which is authorized and regulated by the FCA.

 

© 2024 Lombard Odier IM. All rights reserved.