Over the past decade, the financial landscape has witnessed significant shifts, one of which has gone unnoticed. Correlations. Notably, the correlations between equity and fixed income have increased, and domestic and international equities have become more highly correlated. These trends have profound implications for portfolio diversification and risk management. Important note: correlations change constantly over time.
Traditionally, equities and fixed income have been viewed as inverse relationships. When equity markets perform well, fixed-income markets tend to underperform, and vice versa. This inverse correlation has been a cornerstone of portfolio diversification strategies. However, over the past 10 years, this relationship has evolved. In the graph below, we look at the correlation of the S&P 500, via SPY, and U.S. investment grade debt, via AGG, as high-yield fixed income is historically more highly correlated to equity.
Rolling Monthly Correlations AGG: SPY Over 10 Years
Source: Koyfin (Oct 31, 2014 – Oct 31, 2024)
SPDR® S&P 500® ETF Trust (SPY) seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index.
iShares Core U.S. Aggregate Bond ETF (AGG) seeks to track the investment results of an index composed of the total U.S. investment-grade bond market.
Several factors have contributed to the increased correlation between equities and fixed income. One significant factor is the global monetary policy environment. Central banks worldwide, particularly the Federal Reserve, implemented unprecedented monetary easing measures, including low interest rates and quantitative easing. The pandemic underscored the interconnectedness of global financial markets. Economic developments, policy responses, and market sentiment in one region quickly influenced markets worldwide. This increased integration means that shocks and policy measures have more synchronized effects across asset classes, including equities and bonds.
Similarly to equities and fixed income, the correlation between domestic and international equities has increased over the past decade. This trend can be attributed to several key factors.
Firstly, globalization has led to greater economic interdependence among countries. Multinational corporations operate across borders, and global economic conditions influence their performance. In fact, according to Morningstar, as of 9/30/2024, the S&P 500 derived 40.9% of revenue from outside the U.S. in 3Q24. As a result, the performance of domestic equities is increasingly tied to international economic trends. Secondly, technological advancements and the rise of digital platforms have facilitated faster and more efficient information flow. Investors can now access real-time data and news worldwide, leading to more synchronized market reactions. This increased flow of information has contributed to the higher correlation between domestic and international equities.
Rolling Monthly Correlations VEU:SPY Over 10 Years
Source: Koyfin (Oct 31, 2014 – Oct 31, 2024)
SPDR® S&P 500® ETF Trust (SPY) seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index.
Vanguard FTSE All-World ex-US ETF (VEU) seeks to track the performance of the FTSE All-World ex-US Index.
The increased correlations between equity and fixed income and domestic and international equities present challenges for investors seeking risk mitigation and downside protection, as traditional strategies may no longer provide the same level of diversification. Advisors must explore alternative assets, such as liquid alts, real estate, commodities, or private equity/credit, to achieve effective diversification.
Jared M. Orr, CFP® is a Portfolio Strategist at an asset management company.
This article first appeared in the 2024 Q4 Financial & Retirement Planning Section newsletter.
Editor: Greg Filbeck, CFA, FRM, CAIA, CIPM, PRM, Samuel P. Black III, Professor of Finance & Risk Management, Penn State Erie, mgf11@psu.edu