I say this because it might be a sign that the long period in which equities and gilts moved in opposite directions is over. For example, in the last 12 months the correlation between five-weekly returns on gilts and the All-share index has been zero, whereas it averaged minus 0.26 between 2001 and 2012.
There’s an obvious explanation for gilts and equities rising together. One benefit of the recent shutdown of the US government is that economists now expect the Federal Reserve to maintain its pace of quantitative easing for longer. Rob Carnell at ING say we might not see it begin to scale back its buying of bonds until at least early next year. This means bonds and shares have benefited from hopes of continued plentiful money. In this sense, what we’ve seen has been a mini-reverse of what happened in the early summer, when equities and gilt prices both fell as investors feared the Fed tapering QE.
(The fact that gilt yields have fallen despite growing evidence of the strength of the UK economy reminds us of another important fact – that UK asset prices are determined more by global developments than domestic ones.)
Herein, though, lies a problem. It’s possible that anticipations of US monetary policy will continue to dominate the investment scene for some months. If so, the correlation between gilts and equities could become more positive.
This matters because for most of this century the fact that the two have generally moved in opposite directions has meant that equities have – in a very important sense – not been especially risky, because it’s been easy to protect yourself against them falling by holding bonds. However, if the correlation between the two becomes positive, this protection will be weaker and so shares will in effect be riskier.
You don’t have to look far for a precedent here. For much of the 80s and 90s gilt and equity prices did rise and fall together. In part, this was for the same reason we’ve seen this year; expectations of tighter monetary policy were bad for both assets, and expectations of looser policy were good.
Now, there might be some good news in all this. If equities are genuinely riskier, returns should be higher to reflect this. However, this can only be the case if prices are low now, so that they’ll rise in future. It’s not clear that this is the case; the best reason for thinking so is simply that it’s that time of year.
What we face, therefore, is correlation risk – the danger that assets we’ve thought of as negatively correlated might rise and (worse) fall together. If this happens, hitherto well-diversified portfolios will become riskier than they now seem to be. This is one reason why – despite its low returns – there’s a case for holding some cash.
