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Stocks versus bonds: A potential paradigm shift

John Rekenthaler  |  27 May 2020Text size  Decrease  Increase  |  
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So far, so good

The phrase “risk on/risk off” refers to when the financial markets are binary. Either safe assets rise at the expense of risky securities because investors are pessimistic, or the reverse. This pattern is most apparent when stocks crater, and then during their subsequent rebounds. In the first half of October 2008, for example, US stocks dropped 25 per cent while long Treasuries rose. Equities then rallied for three weeks, regaining 8 per cent of their losses, as Treasuries retreated.

However, stocks and bonds have generally taken opposite paths even when volatility has been quiet. For the decade of the 2010s, when the US equity markets were unusually tame, the correlation of weekly total returns between the S&P 500 and the Bloomberg Barclays US Treasury 20+ Year Index was negative 0.47. That is about as negative as investment correlations get.

The inverse performance relationship has made long bonds valuable for diversifying equity portfolios. Although long Treasuries’ gains have shrunk over the years along with their yields, their habit of cushioning equity losses has sustained their usefulness. Yes, long Treasuries have become less attractive, as the 30-year bond’s yield has dwindled to a puny 1.3 per cent, but at least they continue to offset equities’ risk.

Yet I worry.

Dangerous ground

As Sir John Templeton said, “the four most dangerous terms in investing are ‘this time it’s different.’” Far be it for me to contravene a British Knight Bachelor, especially one who invested so successfully, but on occasion, the established rules fail.

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“There really is such a thing as a “paradigm shift’,” stated another legendary investor, Peter Bernstein. “That means that there’s never a time when you can be sure that today’s market is going to be a replay of the familiar past.”

(In 1981, Bernstein was hired to provide investment advice to a large foundation. He recommended that the foundation purchase long Treasury bonds, which yielded 15 per cent. According to Bernstein, one of the fund’s directors who was the president of a major bank “was so apoplectic at my recommendation he got red in the face. His memory bank was full only of losses—the hundreds of millions, maybe billions, that his bank had lost on bonds for years on end.” The executive did not understand that for bonds, the times truly were about to become different.)

This may be one of those moments. The suggestion is tentative, because every "this time is different" claim is rickety. Mine is particularly suspect because it rests on the shakiest of investment foundations: macroeconomics. None can foretell the direction of global inflation. (More accurately, many can foretell, but none can know.)

Glendower: “I can call spirits from the misty deep.”
Hotspur: “Why, so can I, or so can any man. But will they come when you call them?”

An inflection point?

Nevertheless, I think we should at least consider the possibility that the long-standing stock-bond relationship may be ending. With only brief exceptions, inflation across the developed markets (and to a large extent, also within the developing markets) has been slowly extinguished. In 1980, annual inflation in United States, Japan, and Germany averaged 9.3 per cent; today, that figure is below 2 per cent. As reflected by those countries’ currently low government bond yields, investors expect inflation’s future to look much like its past.

Perhaps it will. However, given the extraordinary amounts of cash that global central banks have created in recent years, inflation may resurface. Not, one fervently hopes, as ferociously as it did during the 1970s. But nothing so dramatic would be required to reduce, if not eliminate, long bonds’ diversification benefit. Even the hint of higher future interest rates would harm both equities and long Treasuries, thereby more closely aligning their returns.

Or, inflation will remain dormant, but the relationship between equity and bond returns will nonetheless change for the intermediate term because the economic levers have shifted. For the foreseeable future, with the coronavirus hampering business activities, government spending will account for a larger percentage of developed markets’ gross domestic product. It may be that the risk on/risk off dynamic will expand to become investments on/investments off. The prospect of higher government activity will boost all investment assets—stocks and bonds included—while lower activity will spur a flight to cash.

March madness

That may be what occurred during March of this year, when the returns for the two asset classes converged. Stocks and long bonds increased during the month’s first week, declined for each of the next two weeks, and then rose again over the final week. Worse yet, foreign stocks (naturally) and gold bullion (surprisingly) followed the same pattern. When US equities, international equities, high-quality bonds, and gold all move in the same direction, there’s not much point to diversifying across asset classes.


Since March, normalcy has returned, with equities and long bonds mostly moving in opposite directions. It would therefore be foolhardy to overstate this case. It is no more than a faint suspicion. But I think the possibility bears watching. Under Paul Volcker’s Federal Reserve leadership, a prolonged investment regime began. Has that process finally run its course?

It's a question worth pondering. If that is the case, four decades’ worth of asset-allocation advice will need to be altered.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is vice president of research for Morningstar.

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