A Diversified Portfolio May Not Help Investors Much This Year

JPMorgan's Nandini Ramakrishnan Discusses the Correlation Between Bonds and Equities

The economy has changed and investors can no longer rely on a diversified stock-bond portfolio to provide protection in times of market volatility, according to JPMorgan Asset Management.

Rising inflation expectations and the knock-on effect of higher yields are acting to prevent bonds from rallying in risk-off environments, global strategist Thushka Maharaj wrote in a recent note to clients. In such a reflationary environment, the correlation between stocks and bonds is likely to go up, reducing the diversification benefits for investors holding both assets, she said.

Over the past 25 years, “the main periods in which correlation turned positive were around Federal Reserve tightening cycles or monetary policy induced liquidity events such as the ‘taper tantrum’ in 2013,” said Maharaj. “In the current reflationary environment, with pro-cyclical fiscal stimulus, it is more difficult to see bonds providing a consistent diversification benefit -- outside of pure growth shocks.”

Recent market volatility partly illustrates JPMorgan’s argument. While the initial reaction to the stock sell-off on Feb. 5 was a jump in 10-year Treasuries, they slumped again the following day. The S&P 500 Total Return Index is down about 3 percent so far this month, but the Bloomberg Barclays U.S. Treasury Index has also declined, by about 1 percent.

Still, a negative surprise on economic growth that sparks a risk-off market environment would lead to a drop in correlations and bonds would outperform, according to Maharaj. It’s just for the next 12 months, at least, she doesn’t see that as likely.

“A sharp rise in inflation that warrants a response from the FOMC is the bigger risk in our view,” she said. “In such an environment it would be hard for duration to act as a diversifier.”

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