In recent years we've come to assume that gilts and equities will move in opposite directions. There are good reasons for this. When investors become more risk-tolerant or more optimistic about the global economy, they buy shares and sell gilts. And when they become less so, they sell shares and buy gilts. The upshot is a negative correlation between the two. It's become a cliché to say that markets oscillate between 'risk on' days - rising share and falling bond prices - and 'risk off' days.
Although this perspective has become normal, it is not the only way to think about the equity-gilt correlation. As the last few weeks have shown, other factors can generate a positive correlation between the two assets. Among these are:
■ Monetary policy. The prospect of tighter policy can cause both shares and bonds to fall as investors shift into cash in anticipation of higher returns. It's no accident that one of the few previous recent occasions when gilts and shares both fell was during the 'taper tantrum' in the spring of 2013, when fears that the Fed would stop quantitative easing reduced both bond and share prices worldwide. With the Fed and Bank of England edging towards raising interest rates, a repeat of this is possible,
■ Supply shocks. Anything that raises inflation and depresses economic activity could hurt both bonds (because of higher inflation) and equities (because of lower growth). It's no accident that the sell-off in both assets has come during a time when oil prices have risen more than 20 per cent - because higher oil prices raise inflation and reduce growth.
■ A changing risk distribution. One reason for bonds' sell-off could be that tail risk has diminished; the risk of a deflationary spiral has receded. However, this has coincided with an increased likelihood of a central scenario of weak growth - something that is bad for equities.
■ Contagion risk. A very sharp drop in global bond prices might itself cause shares to fall if investors fear that banks will suffer big losses on their holdings to the extent that they inhibit their ability to lend.
■ Changing duration preferences. If investors want long-duration assets - those that pay off in the distant future - they'll buy both bonds and equities but if they want shorter duration assets they'll sell both to hold cash. There's a seasonal pattern in these changes. Appetite for duration tends to increase towards the end of the year - bonds and shares both tend to do well in December - but decline in the middle of the year; the three calendar quarters since 2000 in which bonds and equities both fell were all the second quarters.
You might think these forces for a positive correlation are rare ones. Not so. Until the early 2000s, it was more common for gilts and equities to fall together than for them to move in opposite directions, This fact warns us not to regard a negative correlation as normal and the last few weeks as exceptional.
All this matters for investors. It warns us that we should not rely upon bonds or bond funds alone to rise if shares fall. For this reason, cash, despite its nugatory return, still has a place in any well-diversified portfolio.
