Ratio between stocks and bonds

It is on this basis that we advise all investors to build a “balanced” portfolio, the distribution of which between stocks and bonds varies in the proportion of 50/50. Today, this fundamental proposal is no longer valid.

For almost 30 years, since 1966, according to BCA Research of Montreal, the correlation between stocks and bonds has been negative, which has helped create modern portfolio theory. This negative correlation also prevailed for most of the 20th century. When stocks in the portfolio fell, bonds kept it afloat, and vice versa.

However, since 1997, the ratio between the two asset classes has grown steadily, and today the two classes often move in tandem. Worse, bonds offer negative returns, which fall as stock prices fall.

lure

Judge Yannick Desnoyers, vice president and chief economist at Addenda Capital in Montreal, said the idea of ​​a stock-to-bond ratio was a lure. “The ratio between stocks and bonds is a random event, which only on a very superficial level characterizes the evolution of prices of two assets. The financial community is talking about a correlation, but economists are talking about a cause-and-effect relationship. »

In fact, the economist explains, the two categories of assets are subject to very separate economic imperatives, which can sometimes lead to correlations and sometimes not. There is no iron law according to which stocks and bonds must move in different directions. When economic and financial conditions require it, their ratio increases, as is very sharp now; and when conditions dictate otherwise, their correlation decreases.

Thus, Yannick Desnoyers identifies three variables that dictate the “correlated” or “uncorrelated” relationship between stocks and bonds: economic acceleration or deceleration, rising or falling inflation, rising or falling key central bank rates. “The ratio depends on the economic context,” says the economist. Therefore, many have been caught since the beginning of the year. »

For example, in the case of economic slowdown and rising inflation, the “correlation” will increase; however, if the economy rises and inflation falls, the “correlation” will weaken. It all comes down to how inflation and economic downturns raise expectations of future profits and affect asset prices.

“Without inflation and even if there is a recession, the classic 60/40 portfolio will win,” explains Yannick Desnoyers. Stocks are falling, but bonds are doing well: the correlation is weak. Add inflation, and we see a decline in both assets: the correlation is changing. »

The third variable, the key rate of central banks, is designed to change the current strong “correlation”. “It may take a little longer,” said the economist. However, this will return to the opposite recession, when key rates will be high enough to curb inflation. Then the central bank will lower rates, which will improve bond yields, which compensates for losses in the stock market. »

For example, Yannick Desnoers expects the key rate of the US Federal Reserve to reach 4.5%. It is time to return to the bond market, shortly before the key rate reaches this cyclical peak.