Investment Commentary

The conventional wisdom that stocks and bonds are negatively correlated is a central component of most asset allocation strategies. But the correlation hasn’t always been negative – far from it, in fact – and there are increasing signs of strain in the relationship, prompting investors to ask: could the stock-bond correlation flip? In this blog, we consider that possibility, what it might mean for the average portfolio, and how gold could help to protect portfolio performance.

Much has been written about the origins of the negative correlation between equities and Treasuries [here, and here for example], an almost 25-year relationship which emerged in the wake of the 1997 Asian Financial Crisis (AFC) (Chart 1) and the low and stable inflation environment that resulted; an environment equally supportive to both bonds and equities.

The AFC saw inflation collapse in line with the cost of Asian-produced goods. At the same time, central banks began to introduce more explicit inflation targets, ushering in an era of benign, controlled, pro-cyclical inflation, in contrast to the counter-cyclical – often very high – inflation that had previously been the norm. This, among other factors, encouraged investors increasingly to use government bonds as a hedge against equities. And, for more than 20 years, the 60:40 portfolio became a widely-used illustrative standard in portfolio analysis.

Chart 1. Negative equity bond correlations weren't always a thing...

But change is afoot. The steep rise in inflation unleashed by the extraordinary monetary and fiscal stimulus of the last several years may yet prove to be stubbornly persistent or, perhaps worse, volatile – likely heralding a period of stop-start monetary policy. Analysis shows that the rise in core US CPI has been accompanied by increasingly frequent instances of positive equity-bond correlations (Chart 2). Could this be a pre-cursor to a return of the positive stock-bond relationship, arguably the most important input into asset allocation, that was largely in place for decades prior to 1997?

Chart 2. Positive equity and bond correlations are becoming more frequent

Such a shift would place a considerable burden on the 60:40 portfolio.

As a thought experiment, we ran some analysis looking at portfolio performance (both actual and hypothetical) for two time periods: (A) 1973-1997, during which the stock:bond correlation was 42%, and (B) 1997-2021, with its -55% correlation. Table 1 shows the results, with the first column denoting the relevant periods/scenarios.

Period A saw higher portfolio returns accompanied by greater volatility and significantly larger maximum drawdown losses. The Sharpe ratio was similar in Period B, but that is because lower returns in this period were flattered by the negative correlations which restrained portfolio volatility.¹ If we assign the same positive correlation experienced in period A to period B (Scenario C), the Sharpe ratio is reduced quite dramatically to .41 from .50.

Table 1. Actual and hypothetical equity and bond portfolio performance

Extending the thought experiment: what are the potential implications for asset allocation going forward if a positive correlation implies a significant drag on risk-adjusted portfolio performance from bonds? A 60:40 portfolio with lower expected bond returns only returns the Sharp ratio to .45 (Scenario D). In Scenario E, we see that a heftier allocation to equities is needed to bump up the Sharpe ratio to the higher levels seen in A and B. Our analysis suggests a split more like 70:30, with the added risk that a higher equity allocation would make the portfolio more vulnerable to stock market pullbacks.

Bonds will no doubt generate poorer returns going forward. They could also lose much of their diversification and risk-hedging capabilities if they increasingly, perhaps consistently, revert to a positive relationship with equities. And low yields may constrain their response to risk-off events, as investors may view cash as a viable hedging alternative.

Which is where gold enters the conversation. In previous research, we have thoroughly demonstrated the benefit of adding gold to a portfolio and its track-record of improving risk-adjusted returns, due to its uniquely effective role as a liquid diversifier and risk hedge.

In beefing up the equity allocation, the ‘standard’ portfolio would benefit from an allocation to gold given its asymmetric correlation to equities: close to zero when equities perform well, but significantly negative when they don’t. In our analysis, gold’s correlation to equities was largely unaffected by the regime shift in inflation before and after 1997 (scenarios A and B), and gold tends to perform well in a higher, or more volatile, inflation environment.

All of which suggests gold could play a pivotal role in delivering enhanced portfolio performance in the years ahead.

• The risk of stagflation has increased materially since we addressed the topic last year
• Europe appears to be at greater risk than the US, due to higher exposure to soaring commodity prices and a weaker economic position, but alarm bells could soon ring across the Atlantic, too
• Year-to-date, gold has performed well, arguably reflecting the Ukraine crisis and the ongoing reflationary environment
• But should stagflation become widespread it could provide further support for gold as a diversifier and risk hedge

Last year, we wrote a report on the risk of stagflation. At the time of writing, we didn’t envision a return to 1970s stagflation – low growth, rampant inflation and high unemployment – but a milder version, absent high unemployment but where household and corporate ‘margins’ are still squeezed by soaring costs and lower income. That view seems now optimistic.

Economic risks appear more acute, particularly in Europe. The durable goods-driven recovery has morphed into one powered by service spending – less beneficial to the region, given its high reliance on manufacturing. Money supply growth has also slowed markedly, often a reliable harbinger of weaker business confidence and activity. This has been exacerbated by the Ukraine crisis causing a surge in the price of essential commodities such as natural gas (Chart 1). At its most recent meeting, the ECB actually discussed the possibility of a stagflationary shock, even if it doesn’t expect outright stagflation.

Chart 1: Europe has faced significantly higher energy prices compared to the US

Monthly natural gas price*

Contrast this with the US. Although inflation has been setting successive multi-decade records for nigh on a year, both hard and soft economic data are still firmly in expansion territory. This is still a reflationary environment. But events can unfold quickly and some indicators point to the risks of a slowdown alongside soaring prices: The US Treasury yield curve has been flattening at an alarming rate across a number of tenors and consumer sentiment is at a ten-year low (Chart 2). In addition, the Atlanta Fed’s GDP now estimate puts growth at 0.5% in Q1 2022.¹ Should current conditions drag on, the risk of a stagflationary squeeze will rise materially.

Chart 2: Sentiment and GDP are not telling the same story

‘Stagflationary’ environment painful for risk assets… gold to the rescue

Of the four business cycle phases since 1973, stagflation is the one that is most supportive for gold and conversely the worst for risk assets (Table 1).

Table 1: Gold in USD has been the best stagflation performer since 1973

Annualised average adjusted return (AAAR)² since Q1 1973 (all figures in %)*

Gold’s strong performance year-to-date might be following its historical track record in reflationary environments, lagging commodities initially but eventually catching up. The Ukraine crisis has undoubtedly focused more attention on gold’s hedging credentials. Whatever the motivation for the current widespread interest in gold, it is doing exactly what an effective diversifier and portfolio hedge should: providing protection when other assets are faltering.

What may also be benefiting gold here is the lacklustre performance of bonds. Consistent with reflationary periods, bonds have struggled since the start of the year. A broad index of US government bonds has fallen 6% so far and even the Russian invasion of Ukraine failed to muster more than a brief uptick before the downdraft resumed.³ If growth slows significantly and stagflation materialises, history suggests bonds should rally (and yields fall).

There are strong tailwinds for gold at the moment: equity weakness, geopolitical risk, soaring inflation. Weakness in bonds is adding further support, and we are still in a reflationary environment. Should this morph into something more stagflationary – the risk of which is rising – then history suggests it could be even better for gold.

Footnotes

¹GDPnow is a running estimate of a current quarter’s GDP estimate using available information.

²This measure is based on quarterly returns and is used to weight these returns according to the severity of the stagflationary phase. Please refer in the appendix of 'Stagflation rears its ugly head' for further detail.

³ICE BofA US Government and Agency Total Return Index

• Gold tends to rally when credit spreads widen…
• …but that’s usually the case when the move in credit spreads is driven by broader systemic risks
• US spreads have only recently begun to widen. Should this environment of higher inflation and geopolitical tension draw itself out, widening spreads are likely to signal further support to gold

Credit spreads¹ are considered good gauges of market or economic risk. Why?² Bond markets are large. The market capitalisation of US government and corporate bonds totalled US$32tn in Q1 2021 according to SIFMA.³  That makes them a little smaller than US equity markets but arguably more systemically important. This is because they represent funding by government as well as corporations. In addition, bond markets have relatively more certain future pay-outs than equities, with predetermined – albeit not entirely riskless – coupons and principal. Given the greater certainty, bond markets might be expected to incorporate new information more quickly. This may be why bond markets are often cited as ‘smarter’ than equity markets. Finally, there is a reflexive feedback mechanism in corporate credit whereby increasing yields, on fears of higher default risk, can make financing harder which in turn increases the risk of default further. For these reasons, bond markets and particularly credit spreads are watched closely as gauges of risk. When they widen materially it can signal broader fear of market or economic stress.

As a consequence, one might expect gold to rally on widening spreads given gold’s effectiveness as a hedge against market or economic stress. Is this the case? The answer is that it depends.

Taking a risk-sensitive measure of spreads: US high yield corporate bonds less 10-year Treasuries,⁴ we can see that since the 1970s (Chart 1), there are periods when gold rises as spreads widen (green shaded areas), but others when it doesn’t (red shaded area). 

Chart 1: Gold’s relationship to credit spread widening is inconsistent

Why does gold rally with widening spreads in some instances but not in all? In our view, this is down to two factors:

• Gold’s dual nature and multiple demand drivers 
• Credit spreads can reflect more idiosyncratic events; gold responds more to systemic events

Gold’s dual nature is one of key drivers of its low volatility and uncorrelated behaviour. It has diverse demand from both a usage and a geographic perspective. As such prices sometimes respond to drivers outside the sphere of US and investor considerations. This is a good thing, as it helps explain its near-zero long-run correlation to risk assets and relatively low volatility. 

The second reason is that when gold responds positively to widening credit spreads, this appears to be linked to more systemic events: Black Friday, the Global Financial Crisis, the 2020 COVID selloff to name a few. Any widening in spreads that is not deemed to be systemic and perhaps only reflecting sector or company-specific default risk, asset allocation decisions, or just falling Treasury yields - is unlikely on its own to drive investors towards gold as a hedge.  Chart 2 shows how gold tends to react to credit spread widening when it is accompanied by a rise in the National Financial Conditions Index (NFCI) – a broad proxy for systemic risk.⁵  The 1991 Gulf War, the Dot Com bubble and ensuing recession as well as the commodity-led slowdown in China in 2014-15 are examples of non-systemic spread widening events in which gold prices didn’t respond in kind.

Chart 2: Gold reacts to credit spreads widening when they are capturing more systemic risk episodes

What are US credit spreads telling us about gold now?

Markets are volatile once again in 2022. Inflation, monetary tightening as well as geopolitical risk are all key drivers. These developments could create snowball effects that impact the credit markets. 

But credit spreads have only recently started to widen. In 2022 HY spreads have moved only slightly to around 400bps (Chart 3). This is below the 10-year average (440 bp) and well below spikes we saw during the GFC (2,000bps), and COVID (1,100bps).

Chart 3: Credit spreads have barely budged despite soaring inflation and the Ukraine crisis

The lack of movement in credit spreads in the face of soaring inflation and heightened geopolitical risks could be attributed to several factors., A combination of historically low government bond yields and excess stimulus money have drawn investment into higher yielding products, which have pushed spreads tighter. In addition, bond market participants seem to expect that the Ukraine may have a limited impact on the US economy, which remains in reflation mode. This has contained Treasury yields from moving lower relative to the High yield component of the spread. 

Even though many equity indices are near bear-market territory, there has not been a significant impact on perceived creditworthiness or the underlying economy. Equities may just be repricing on the basis of elevated inflation, which has been exacerbated but not solely driven by the war.

But gold is nonetheless higher on the year. The combination of higher inflation and geopolitical uncertainty is drawing investors to gold as a hedge. Gold is also a global market, and while US bond investors may seem more confident, other investors – whether in Europe or elsewhere – are likely responding more to the potential ramifications of the armed conflict.  

But if either high inflation or the Ukraine crisis become drawn out, we could see a material impact on US economic growth as well. That would likely send US credit spreads higher on more systemic grounds and further bolster support for gold going forward. 

For a third consecutive year we partnered with Pensions Age to survey UK pension professionals about their views on gold and whether it features in their asset allocation. In this video I summarise the survey’s findings, which suggest that UK pension funds may be looking to gold and increasingly recognising its diversification potential.

See the results

Table 1: Gold return in key currencies year-to-date*

Gold has outperformed what simplistic models suggest. A commonly used model based solely on the direction of the dollar and real rates suggests gold should have been 21% lower than it is now (Chart 1). But last year we highlighted the pitfalls of relying on such a simplistic approach. Why? First, gold’s correlation with the dollar is not always negative. We’ve seen this correlation flip to positive over the past few months – as it has done in the past. Second, rising interest rates can make gold less attractive if they raise the opportunity cost or reflect higher economic growth ahead. Neither of those appear to be true at present. Growth expectations are falling and the opportunity cost – correctly viewed in real terms – remains historically low. 

Table 2: Gold’s performance under negative and moderate interest-rate conditions*

The Fed, along with many other central banks, appears to be playing catch up in its attempts to control inflation. If the economy was weathering the prospect of higher rates better, then the story might be worse for gold. But stagflation risks are mounting with every data print, which is supportive for gold in our view.

3. Can you explain why gold and oil seem more correlated recently?

Oil and gold have become more positively correlated over the past year or so (Chart 2). While this happens from time to time, the long-term correlation between the two is generally close to zero, sometimes oscillated between negatively and positively correlated over the last 25 years. For example, the correlation turned negative at near the start of the pandemic in 2020, when oil settled at a negative price and gold rallied 25%.

The rationale for the recent positive correlation centres around heightened geopolitical uncertainty, which has not only boosted the performance of commodities – particularly energy – but also gold specifically, in its role as a hedge. As we’ve discussed previously, gold often lags other commodities in reflationary periods. It is almost a cause-and-effect situation where commodities move higher, creating inflation that some investors then hedge with gold.

4. Where is central bank buying headed?

During a turbulent first quarter marked by geopolitical crises and surging inflation, central banks globally added 84t of gold to their reserves. While this is 29% lower y-o-y, it is more than double the previous quarter and, in the main, reflects buying by a few emerging market central banks. This healthy level of demand corresponds with the findings of our 2021 central bank survey: for the first time respondents highlighted gold’s performance during periods of crisis as the top reason to hold gold.

Looking ahead, gold might attract further interest as a diversifier as central banks seek to reduce exposure to risk amid heightened uncertainty. We expect central banks to remain net purchasers in 2022; however, slower economic growth and rising inflation may restrain this demand in the short term. We also caution that active management of reserves can result in selling during crises to take advantage of gold’s abundant liquidity.

The results of our 2022 central bank gold survey will be published by the end of June.

Retail investors were enthusiastic buyers of cryptocurrencies last year. A global study by Hall Partners shows that cryptos were one of the most popular investments in 2021, with 31% of respondents investing in them over the first 10 months of the year.¹

These investors might be suffering. The crypto universe has been extremely volatile over the past six months, unsettled by a mix of tightening liquidity and negative economic data prints. More recently, the collapse of Luna and TerraUSD caused stablecoin Tether to temporarily decouple from its $1 peg, sparking additional jitters. Bitcoin has halved in value in a little over six months, while the Bloomberg Galaxy Crypto Index has lost almost two-thirds of its value over the same period.²

We’ve been here before with Bitcoin. More than once. The crypto behemoth has previously lost 50% of its value on five separate occasions since its inception, so the latest move is not without precedent. 

But the research suggests that these investors seem to be aware of the potential pitfalls of investing in cryptos: 32% of investors viewed their crypto investment either as ‘high risk with the potential for high returns’ or as a ‘purely speculative bet’. Mirroring that sentiment, only 6% agreed that cryptocurrencies are ‘a safe investment that I don’t have to worry about’.³

Attitudes towards gold among these investors are contrastingly different – they recognise its safe-haven, inflation hedging qualities. One third of investors view their gold investment as either ‘a store of value (to protect my wealth)’, a way to ‘protect against inflation’ or as ‘a safe investment that I don’t have to worry about’. ⁴

Which may explain why even more investors bought gold than crypto last year. According to the research, 44% invested in gold in the first 10 months of 2021, with bars and coins among the most popular options. That’s reflected in our Gold Demand Trends data, which showed 2021 bar and coin investment reaching an eight-year high.

Of those investors who bought cryptos in 2021, just over half also made an investment in gold. Assuming they still hold both assets, that group could be forgiven for feeling smug. At the time of writing, gold is one of the best performing assets since the start of 2021.⁵

While a gold investment may not have made stellar returns over that time, it’s at least likely still to be in the black, fulfilling that role of being a store of wealth and a safe worry-free investment. And giving those investors who hold it more dry powder to invest elsewhere.

Footnotes

¹The World Gold Council commissioned Hall & Partners to survey 10,000 retail investors across five markets US, Canada, Germany, India and China. Retail investors were defined as people who are aware of both gold and cryptocurrencies as an investment product, and who had made at least one investment (from a defined set of investment products) since the beginning of 2021. Online fieldwork was conducted in late October/early November 2021.

²Drawdown between 10 Nov 2021 and 20 May 2022. The Bloomberg Galaxy Crypto Index tracks the performance of the largest cryptocurrencies traded in USD. See: BGCI Quote - Bloomberg Galaxy Crypto Index - Bloomberg Markets

³The survey asked investors to select up to three statements to describe the role of each of the investment products they currently owned. The statements were selected in order of importance, with the first selection being the main role of this investment. Sample sizes: owners of gold, responding for each gold investment product, (7,352); crypto owners (2,983)

⁴Respondents ranking each statements between 1 and 3 for all gold products

⁵For gold’s performance versus a range of stock, bond and commodity indices in various currencies, see Gold Price Returns 2021 | Gold Prices | World Gold Council. Customising the data to start from end-Dec 2020 shows that, as at end-April 2022, gold (in US dollars) had outperformed all other variables except the MSCI US Index and the BBG Commodity index.

Francisco Blanch, Head of Commodities and Derivatives Research at BofA Global Research, joins us for this episode of our Strategic Edge series.

In conversation with our Global Head of Research, Juan Carlos Artigas, this two-part video explores timely topics including... 

• Impact of inflation, rates on gold and other commodities
• Is a commodities supercycle imminent?
• Outlook: key considerations for  H2 2022

Part 1

Part 2

I recently joined Ed Monk on Fidelity International's MoneyTalk podcast for a conversation on gold. 

We discussed gold's lasting appeal, as well as the prospects for gold in a world of high inflation, crypto currencies and ethical concerns about its extraction from the earth.