Traditional Portfolio Diversification Is At Risk

Written by Richard Turnill

Donald Trump’s election victory drove up 10-year U.S. Treasury yields and pushed the S&P 500 near record highs, reinforcing the inverse bond-stock relationship. We expect this relationship to be less stable as markets digest a stronger U.S. economy and Trump’s potential policies, and suggest investors rethink diversification.

One hallmark of the early post-crisis environment was a stable negative correlation between long-term U.S. Treasury and equity returns – bond returns being positive when stock returns took a hit. This stable relationship started to break down when the Federal Reserve signaled tapering in 2013. It has become even more unstable lately, as the chart below shows.

U.S. equity and government bond return correlation, 2011-2016

A regime shift for financial markets

This recent instability comes as yields have jumped from July record lows and investors have become concerned about the implications of higher bond yields for equity valuations. This was seen in September when the one-month Treasury-S&P 500 correlation flipped to its most positive level in a decade.

If this bond-equity relationship remains unstable when yields are at risk of climbing further, long-term Treasuries may not play their traditional portfolio diversifying role. We believe the jump in benchmark U.S. Treasury yields after Trump’s surprise win, and the accompanying move toward cyclicals and away from bond-like equities, represent an important regime shift for financial markets and highlight risks to traditional portfolio diversification.

Treasuries remain effective diversifiers if risky assets take a hit, but our analysis suggests other ways to diversify in a rising interest rate environment [as follows]:

• We favor shorter-term bonds whose returns are partly shielded from higher yields.
• We prefer value stocks, those that look relatively cheap on metrics such as book value and tend to perform well when bond yields rise.
• We particularly like value sectors such as financials, energy and industrials.
• We also believe investors should be flexible and consider a tactical approach given the uncertain outlook.