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Notes on the relationship between equities and bonds with respect to yield and inflation dynamics

Reading time 10 Minuten

The bond/equity relationship is not linear. Rising interest rates and yields are not necessarily bad or good for equities, it depends. At the start of, or in anticipation of, an economic recovery, bond yields typically rise because of expected pressure on resources and rising demand, which in turn feeds inflation expectations. But the prospect of rising consumption and investment is a good thing for equities. In this sense, higher interest rates (and higher inflation expectations) signal a positive framework for equities, especially when they follow a period characterised by a rising risk of deflationary dynamics, as was the case last year. Theory teaches us that the level of inflation per se is not a problem, rather the fact that higher inflation is associated with uncertainty or high inflation volatility. This in turn increases the risk premia and the interest demanded by investors. This is one of the reason why central banks put a lot of effort in building inflation expectation.

Inflation, real rates and equity valuation

The worldwide increase in interest rates in the second half of February has surprised the market and had a negative impact on equities. The major focus was on US Treasury bonds and USA inflation which act as bellwether for the financial markets. However it is true that in the USA the current level of inflation and real yields is still well below the level that was historically considered problematic and became a structural headwind for equities. We report below the analysis published in a recent study by Morgan Stanley. On average higher yields are indeed bad for equities beyond a certain point: increases in CPI and real interest rates above 3% have historically been associated with lower P/E ratios. But current CPI in the USA is still below 2%, expected average inflation over the coming 10 years (measured by breakeven inflation on inflation linked Treasury bonds) is at 2.25% and real yields are at zero or negative across the curve - so there is still plenty of room for increases in both areas before multiples come under pressure. In Europe and Switzerland the inflation dynamic is more subdued and definitely less critical than in the USA.

Inflation, real rates and bond/equity correlation

Another aspect of great interest for investors is the impact of interest rates and inflation on the bond/equity correlation. The much feared flip in bond/equity correlation also likely needs further increases in inflation before there is a structural shift. Stocks remain negatively correlated to bonds, and that tends to not flip on a sustained basis until inflation and/or real yields rise above 3%.

Segmenting the correlation by CPI or real rate we see that for higher inflation level the correlation becomes positive. This poses a significant asset allocation problem since at a higher inflation and interest rate level bonds per se become more volatile and risky, reducing the risk mitigation effect when combined to an equity portfolio. Besides the higher correlation, this reduces the stabilization and diversification effect.

Bond/equity correlation and equity valuation

But that is not the end of the bad news associated to rising inflation and implicitly to rising bond/stock correlation: valuation multiples contract on average up to 20% implying a negative equity performance. 

We are unable to anticipate where inflation, nominal and real yields will be in the future. Current level of real interest rate and inflation do not seem to pose a problem yet, at least based on long term historical evidence. Nevertheless unorthodox monetary and fiscal policies in recent years have fueled fears of a substantial rise in inflation. Based on the historical evidence for the US mentioned above, this in turn poses major problems for the asset allocation and performance of a multi-asset class portfolio. In a rise in inflation, bonds tend to be more volatile and positively correlated with equities, thus less risk mitigation and diversification. A risk-based asset allocation helps to stay closer to the risk budget, limit losses and stabilize the portfolio.

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