Andrew Pyle
November 10, 2023
Sometimes things just feel too correlated
I hope all of you have weathered the time change and minus temperatures this week. Before I start this week’s discussion, I want to first take this time to remember all of those brave souls who have made the supreme sacrifice in years past and in this present moment to guard against tyranny. Whatever time or geography, we will remember them.
I also want to draw attention to a little rebranding that we have put in place this past week. As many of you know, a number of years ago, the team was named Pyle Wealth Management. When the previous firm went through its own marketing change, we had to replace the team label with Pyle Group. We carried that with us over to Wood Gundy, but it’s time to return so to speak to something that better defines who we are. You will notice that the website has changed to pylewealth.ca (thank goodness, no more hyphens) and the official team name is now Pyle Wealth Advisory. Which is what we have always done – manage wealth and provide solid advice.
A key investment component of wealth management is to generate a risk-adjusted return consistent with a portfolio’s objectives and risk tolerance. In normal times, this is achieved through relatively simple diversification across the two main asset classes – equities and fixed income, or bonds. I say normal in that we typically think of the two as usually being fairly uncorrelated. In other words, if the stock market goes down, bonds normally hold value or (in the face of recession) rise in value, and vice versa. This is the premise of the balanced portfolio – a construct that can generate more stable returns over time and even out the swings of an equity-only account.
As most would concur, the last few years have not been that “normal”. There have been periods where both markets have moved in different directions, however, as we have seen since the beginning of 2022, stocks and bonds are tending to move in more alignment. The chart above shows the U.S. 10yr government bond future against the S&P500 over the past 20 years. On a long-term basis, it does show that both bonds and stocks had trended higher until at least the pandemic. During this period, we would definitely see examples where stocks rose and bonds gave back. The chart does indicate an apparent break since 2020, where stocks have outperformed bonds, though since central banks started hiking rates there has been episodes where both are moving in tandem. The following chart focuses in on the last two years.
The AI-fueled rally in U.S. stocks in the second quarter seemingly broke the positive correlation between bonds and the broader equity market but, sure enough, that correlation returned by the end of summer. Business media was filled with doom and gloom in both assets. Central banks were going to keep interest rates high for a prolonged period of time, dashing hopes for rate cuts, sending bond prices lower and pushing stock valuations down alongside them. Then, last week, the Federal Reserve took a pause from rate hikes and everyone felt more comfortable with the view that bond yields had peaked. Both markets rallied right through into Wednesday of this week (Canada’s TSX kept pushing higher, thanks to stronger than expected earnings).
There have been a number of reasons put forward as to why stocks and bonds have deviated from the classic negative correlation to one more positive. The common reason is that, at least in the U.S., the equity market has become longer in duration due to the increased market weighting in technology-related companies. In 2021, interest rates were low and the tech sector fed voraciously off that yield chasm. Sending rates higher in 2022 and this sector fell like a stone. As we know from the past several weeks this post-pandemic adjustment, much like the ripple from a stone thrown in the water, is continuing; though perhaps it might moderate or normalize into 2024.
Much like any injury, there is going to be scar tissue in this market re-alignment and that suggests that we are not going back to our previous notion of normal any time soon. It is indeed possible that positive correlations, albeit smaller, will still exist between stocks and bonds. This is a conundrum for investors that have been used to traditional balanced portfolio strategies. It doesn’t mean the strategies have to be thrown out the window – we just need to augment them with alternative investments.
Ally and I have talked to clients over the past couple of years about this very situation and we have implemented strategies on both sides of the asset ledger that can get us out of the hair-pulling positive equity-bond correlation dilemma. That has included using so-called liquid alternative bond and stock funds that can generate low-correlation and lower volatility. On the bond side, this means generating positive total returns when yields are rising (bond prices are declining). For stocks, it means either a covered-call strategy designed to generate more income or a cash covered put strategy to again generate higher yield and reduce downside risk.
There are other alternative strategies, however, that we can employ. At its core, the definition of an alternative asset is something that is neither equity or fixed income. The most common alternative asset out there, and one of the oldest, is gold. While holding physical gold does not create an income stream, the yellow metal does check the boxes on a number of objectives. First, it has held up well as a good capital preservation tool in times when the world is just a little wonky. Second, it is still a useful hedge against inflation, which we have seen since the pandemic. Third, it can be a useful counterweight to a decreased level of confidence in the ability of governments to rein in debt – something which is very relevant today.
Not only have spot gold prices performed well since the beginning of the pandemic but, in real terms, gold has held its ground. What I mean by real is that the ratio of the price of gold to general price levels (in this case, the U.S. CPI index) has trended higher over the past 20 years and is well above its long-run average (since 1971, when Nixon decided to jettison the gold standard). If you listen to enough U.S. radio, then you will have undoubtedly gotten tired of listening to people say you can convert your entire investment account into gold. The rationale is that financial markets are going into spiral and the U.S. dollar along with them. Clearly this is an extreme position, but underneath the hyperbole is the acknowledgment that global government debt is on an unsustainable path (higher).
True, gold prices didn’t advance from the mid-1980s to 1995, when we thought fiscal deficits were out of control. They were a fifth of where we are trading at today. The main reason is that debt back then was a drop in the bucket compared to current levels, even though it was enough to cause gyrations in the market. We had also come off a major dose of inflation in the late 1970s. Today, we believe that there is a good argument to add an additional alternative layer through gold to hedge against debt concerns and lingering inflation worries.
Another growing segment of the alternative investment space is private credit and private equity. Both have been around for a long time but are maturing to the point where investors can achieve improved liquidity that wasn’t possible in the earliest incarnations. Banks have stepped back from areas where they may have normally lent to, creating a void that private credit is filling. While these investments can involve risks beyond traditional asset classes, they can also achieve diversification, lower overall portfolio correlation with equities and bonds and potentially higher returns.
The bottom line is that global financial markets are evolving to a place where the playbooks of the last several decades need to be revised. The core premise, however, of achieving the right asset allocation and taking tactical advantage of opportunities in the traditional bond and equity segments still holds. This will require investors, with the help of their advisors, to advance their understanding of markets today and in the future, and it will definitely require advisors to remain on top of developments.
We will be holding our monthly market update conference call on November 14th at 7:00pm ET. The dial in details can be found below.
Toll-free dial-in number (Canada/US): 1-800-806-5484
Local dial-in number: 416-340-2217
Participant passcode: 4920262#
On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. He and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.