Recession will end the correlation between equities and bonds 

by | Jan 26, 2023

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As markets shift focus to recession from inflation and interest rates, the positive correlation between equities and bonds will reverse, offering investors a wider range of investment opportunities, according to Colin Dryburgh, multi-asset investment manager at Aegon Asset Management.

With concerns mounting about an impending recession, Dryburgh says central banks will take the foot off the interest rate pedal to avoid causing a severe economic downturn. But he says the correlation between equities and bonds is still likely to flip from positive to negative if history is any guide, offering greater diversification opportunities. 

“As global economic concerns shift from high inflation to weak growth or recession then the case for central banks continuing to tighten monetary policy will abate, he says. “This should be supportive for longer-term government bonds and other high-quality fixed income instruments. 

“The correlation between bonds and equities typically declines as economic growth deteriorates. For example, as the US economy approached recession in both 2002 and 2009 the equity bond correlation flipped from positive to negative.  

 
 

“The equity bond correlation was positive in 2022 but should flip to negative as growth weakens. Multi-asset funds should therefore benefit from greater diversification opportunities in 2023.”

Valuations have already adjusted in equity markets, according to Dryburgh, taking them closer to the long-term average. This should, he says, give equity investors less of a headache this year, although he believes the chance of recession in western economies is currently a close call.

“Valuations, now close to their 20-year average levels after last year’s sell-off, should be less of a headwind for investors in 2023 than in 2022, but global economic growth is slowing on the back of tighter monetary and fiscal policies.

 

“It is a close call whether western economies avoid recession this year. The US yield curve is currently inverted, and this typically precedes a recession. Should a recession occur then corporate profits will decline, and risk asset prices will likely face further downward pressure.” 

He points out that many of the factors that drove inflation higher have abated or gone into reverse, with Covid-related production constraints and supply chain bottlenecks easing. A two-year surge in most commodity prices has ended, despite Russia’s ongoing war in Ukraine. The price of brent crude, for example, ended the year a third below its March peak.

“However, China continues to be a source of global economic uncertainty due to its dual real estate and Covid crises,” he says. “Its success (or lack of) at opening its economy and managing its real estate sector could have significant investment implications.”

 

Looking at positioning for investors, this change in the correlation between equity and bond markets should lead investors to make fixed income a larger proportion of portfolios. 

Dryburgh warns however that the environment might shift again this year, making riskier assets more attractive. 

“Fixed income investments should clearly, for now, play a larger role in multi-asset portfolios than in the recent past and, given the challenging economic outlook, equity allocations should favour high-quality stocks with strong balance sheets and low economic sensitivity.  

 

“As the year progresses though, the investment environment may dramatically shift. Should financial markets quickly move to price a recession in 2023 then investors will be provided with an attractive opportunity to shift their asset allocation from defensive assets towards riskier assets at more attractive levels.”

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