Equity-Bonds Equilibrium and Inflation Uncertainties
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| Marc Chagall - Cirque Bleu (1950-1952) |
Bonds-Equity correlation is positive again!
The correlation between Bonds and Equity returns is moving fast these days: in a few weeks it has moved from -70% in February to +12% this week.
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| Equity-bonds Correlation - Source: Google Finance |
Is this move into positive territory abnormal? What are the factors driving this change of sign? Does it mean that investors should change their Bonds-Equity allocation? Is that a warning signal for the fixed-income products?
Back to the pre-2000 regime?
A positive correlation between the returns of bonds prices and equity prices means a negative correlation between bonds yields and equity returns; this inverse relationship between equity prices variations and yields had been actually prevailing before 2000. As explained by Ranking & Shah Idil, in their paper “A Century of Stocks-Bonds Correlations”, Royal Bank of Australia, 2014 :
The recent [last 14 years] period of positive correlations has been commonly ascribed to the emergence of a ‘risk-on, risk-off’ paradigm, whereby US Treasuries and equities have served as proxies for ‘safe-haven’ and ‘risk’ assets, respectively, and broad shifts in risk sentiment have had an unusually large role in determining asset price movements. However, it is notable that the stock-bond yield correlation had already been positive for most of the decade before the global financial crisis.
Fundamental Drivers of Stock Prices and Bond Yields
Again, as described by the two economists of the Australian Central Bank:
Yields on longer-term government bonds are determined by the expected path of the risk-free rate (over the life of the bond), plus a term premium that compensates investors for uncertainty about potential future changes in the value of the bond stemming from changes in real interest rates and/or inflation. A firm’s stock price is determined by the present value of expected future dividend payments, with future payments discounted by the expected path of the risk-free rate and an equity risk premium (the additional return over the risk-free rate that investors require in order to hold riskier stocks). At a more fundamental level, these variables reflect expectations for, and uncertainty about, growth and inflation. In particular, changes in investors’ central expectations for growth and inflation determine their forecasts for dividends and interest rates; stronger economic growth and higher inflation increase interest rates (via actual or expected future policy tightening) while also raising dividends via increased corporate profits. The extent to which there is uncertainty about these variables influences stock prices and bond yields via the equity risk and term premia. An increase in uncertainty about growth raises the equity risk premium while plausibly.
Uncertainty on rates and inflation are clearly growing these days:
The “core” inflation rate, which strips out energy and food prices, unexpectedly ticked back up to 1.8 per cent in March, and many economists expect wage growth to pick up further in the coming year as the US labour market becomes tighter.
As a result, some investors are reappraising the outlook for prices and shifting some of their bets on interest rate policy. Ahead of the US central bank meeting on Wednesday, daily deposits into global inflation-protected bond funds monitored by EPFR Global indicate that inflows have hit a weekly record, with US funds dominating investor interest. Financial Times, April 27th 2015 - http://ow.ly/3xOFlX
To what extent this uncertainty on rates and inflation are impacting the Equity-Bonds Equilibrium?
The Minimum Variance Equity-Bonds Equilibrium
Let us consider an investor willing to find the best equity-bond allocation to face uncertainties in this period of rapid changes. What would be that allocation and how stable is this optimal decision in the current changing environment?
Read full paper here.
Interpretation
of the Minimum Variance Equity-Bonds Equilibrium: early signal on
fixed-income risk
Does our simplified 2 assets allocation model imply that investors
are in average holding a 30-70 Equity-Bonds portfolio? Of course not,
there exist a strong diversity of portfolios depending on investors
various investment horizons and associated expected returns.
Yet
an interesting fact can be observed: each time uncertainties on
inflation are growing fast enough to produce a very steep slope on
some the Equity-Bonds correlation, outflows in fixed-income funds can be observed.
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| Source: Prax Value - Google Finance |
This
Equity-Bonds correlation can be used as a complimentary estimation of
the Breakeven Inflation rate:
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| FRED Economic Data - St Louis FED |
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