Unhedged Commentary: Beware the End of Risk On/Risk Off

July 18, 2016  

   Dean Curnutt, Macro Risk Advisors
By Dean Curnutt

Despite the historical negative correlation between stock and bond prices, it is time for investors to seriously consider the impact of the conventional risk on/risk off model on their portfolios.

Since the end of the global financial crisis of 2008, the correlation between stock and bond prices has been consistently negative, as the corresponding rally in U.S. Treasuries on days when the Standard & Poor’s 500 stock index has fallen has provided a meaningful shock absorber for diversified portfolios. In fact, since 2010 a 50-50 portfolio of stocks and bonds has produced twice the Sharpe ratio of one invested in stocks alone. Over this period the correlation of returns between the S&P 500 and the iShares 20+ Year Treasury Bond ETF has been -55 percent. If stock and bond prices move inversely, do they not mostly net out, limiting the returns of an equity/bond portfolio over the long run? While their movements are largely offsetting day to day, over a longer horizon both stocks and bonds have experienced dramatic returns since the financial crisis. On a total return basis, the S&P 500 is up 109 percent and the iShares 20+ year Treasury Bond ETF is up 85 percent since 2010.

Stock and bond prices have never expressed such different outlooks for growth dynamics. Work by Greenwich, Connecticut–based asset management firm AQR Capital Management points to the "joint richness" of stock and bond prices. There have certainly been periods in which stock prices were more richly valued. The S&P 500 carried a price-earnings multiple of 30 at the peak of the technology bubble in late 1999. But at that time the nominal ten-year Treasury yield was north of 6 percent with break-even inflation at merely 2 percent, leaving real yields at 4 percent. A forward P/E of 17 and a real yield on the ten-year at zero means that today’s environment consists of valuations that are concomitantly stretched for both stocks and bonds. In my conversations with pension funds, I’m asked consistently to help design hedges for risk parity strategies. There is a great deal of capital committed to strategies that rely on the continuation of a negative correlation between stock and bond prices.

This leads us back to the outlandishly strong risk-adjusted performance of a portfolio that is long both stocks and bonds. As we have seen consistently in markets, winning trades acquire an irresistible track record, providing compelling ammunition for advisers and consultants who lean heavily on back-tested results when making recommendations. Fearing a 2008 style meltdown, investors have been drawn to less risky portfolio constructions, especially when they can deliver similar returns.

The so-called taper tantrum of 2013, now celebrating its third anniversary, is a risk event worth constantly thinking about. The dislocation that beset markets was spawned by a sharp reversal in stock and bond correlations. During that time, instead of rallying on risk-off days, faltering bond prices became the impetus for stocks to fall. While the U.S. Federal Reserve quickly went into damage-control mode, the repricing of risk premia across asset classes was swift. Now, with stock prices just south of an all-time high, expectations of continued earnings growth and a very full market multiple, the Fed is expected to do almost nothing, not just this year but in 2017 as well.

In finance, we are taught that there is no free lunch. Realistically, however, market-pricing regimes that exist for lengthy periods of time are enablers of just this suspect notion. Specifically, the persistent and significant negative correlation between stock and bond prices has served as the most important diversifier post–financial crisis, with tremendous implications for how investors size portfolios. In fact, an entire industry of products has been built on the appeal of back-tests that illustrate how leverage can be utilized to achieve better risk-return outcomes for long stock/long bond portfolios. The impact of utilizing this leverage leans heavily on a continuation of these correlation dynamics. The volatility of a 50-50 portfolio shifts dramatically higher when the correlation moves higher.

The undoing of risk on/risk off could be an absolute disaster for markets. The threat here is especially prominent right now given the joint levitation of both asset classes, likely a central bank policy outcome, and the degree to which the realized diversification has spawned an entire industry of products built on an appealing back-test. Higher inflation, for the very reason investors and central banks cannot see it materialize, stands out as a factor that could sponsor substantial deterioration in both stock and bond prices.

Given the threat posed by the potential that stocks and bonds sell off in unison, investors should develop an understanding of the hedging strategies available to defend against just such an event.

Dean Curnutt is CEO of Macro Risk Advisors, an equity derivatives strategy and execution firm that specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York–based firm is a registered broker-dealer with FINRA.

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