6-month equity bond correlation of daily returns (MSCI ACWI total return, Bloomberg Global Bond Aggregate Index, rhs), US cash rate expectations based on forwards, 6 months from now, in % Source: Bloomberg, UBS, March 2023

It takes two to tango, according to the old saying. But the idea of a balanced portfolio is that if one dancer doesn't perform well, the other one can lead, and save the show.

But in 2022, the show disappointed investors 50% of the time with equities and bonds falling in tandem six months of the year. Rates volatility proved to be a powerful driver of both equity and bond market performance; interestingly the equity market low on 12th October coincided with a peak in rates volatility (based on the MOVE Index) at 2009 levels.

January got 2023 off to a good start, with global equities up 7.2% and bonds delivering 2.3% on a total return basis. Both equities and bonds rallied on hopes that the Fed would be able to engineer a soft landing, and that rates would peak at around 5%.

But in February the music changed back to the sound of 2022: A blockbuster jobs report in the US, with 517k new jobs created, more than twice the expectation, showed an extremely tight US labor market. For any remaining doubts on what that meant for inflation, January data, both CPI and PCE inflation, the Fed's preferred measure, beat expectations (CPI 6.4% y/y vs expected 6.2%, PCE 5.4% y/y vs 5%).

This week, data also showed the ISM Prices paid component surging to 51.3 from 44.5. Fed speakers played their hawkish part too. Federal Reserve Bank of Atlanta President Raphael Bostic brought back the specter of the Great Inflation of the 1970s. “History teaches that if we ease up on inflation before it is thoroughly subdued, it can flare anew, (...) That happened with disastrous results in the 1970s." He noted that after the Fed loosened policy prematurely, it took about 15 years to bring inflation under control, and then only after the Fed funds rate hit 20%.

Markets are now pricing a peak rate of 5.5% in September up from 4.9% at the beginning of February, while a Fed policy pivot looks distant. The chart above shows two things: first, correlations have kept on rising since 2022, and, second, rising correlations have closely tracked rate expectations. As investors seeing inflation staying high have repriced their (cash) rate expectations, equity-bond correlations have been on the rise too. Historically, correlations have tended to increase with rising inflation. Higher inflation and higher rates hurt both stocks and bonds. Companies' future cash flows are discounted at a higher rate, and bond prices fall with rising rates. The worst possible 'show' for investors.

So, clearly, investors need to be more selective in choosing their 'dancers', and they need more dancers too.

We advise a selective approach in both equities and bonds. In equities, we recommend diversifying beyond the US and growth stocks which are highly exposed to rising US rates. For example we like value, including energy, which tends to outperform growth stocks if inflation proves sticky.

In fixed income, selectivity is key. Rates volatility will remain high with uncertainty over policy rates in the US and elsewhere, so the return outlook for high quality bonds looks more attractive than for bonds with higher credit risk as breakeven yields can cushion potential mark-to-market losses. High-quality bond prices tend to be supported by falling government bond yields during periods of recession, which tends to outweigh the
impact of rising credit spreads.

And more 'dancers' are needed for diversification to be more effective in a changing and uncertain market environment: portfolios should also include hedge funds which offer uncorrelated sources and can deploy different strategies that are able to thrive in different market conditions.

When the music changes, the dance has to change too.

Main contributor: Linda Mazziotta