Cross-Asset Correlations: Constructing Portfolios amid Market Turbulence
For more than 20 years, multi-asset investors have benefited from the inverse correlation between stock and bond returns to help weather the storms of market turbulence. But following COVID, the combined shocks of supply disruptions along with monetary and fiscal stimulus turned this correlation positive, adding a further challenge to portfolio construction. As multi-asset portfolio managers, we’re tasked with examining not only investment opportunities across different asset classes, such as equities, fixed income, foreign exchange, and commodities, but also the inter-relationship between asset classes, which is an integral component of asset allocation decisions. Positive asset return correlations may correspond to higher returns, but at the cost of less diversification.
One cross-asset relationship we monitor on PGIM Quant’s multi-asset dashboard is the equity/bond return correlation. Figure 1 (below) illustrates this rolling correlation over the past year. For a brief time, the positive equity/bond correlation that followed COVID turned negative in March 2023, but rising inflation concerns drove it back into positive territory in July. This reduced diversification opportunities for multi-asset investors. And while the rising 10Y treasury yield has sent the correlation lower in early 2024, it remains moderately positive.
Figure 1
Since commodities may also provide a potential hedge during periods of market turmoil, we similarly monitor the equity/commodity correlation on the multi-asset dashboard. Figure 2 (below) shows that the rolling correlation of returns between US equities and commodities has decreased significantly since October 2023, making commodities an attractive risk diversifier within a multi-asset portfolio.
Figure 2
Here, we’ve examined just two return relationships – equity/bond and equity/commodities. But it’s essential to assess multiple cross-asset correlations to understand how assets interact with one another in order to make asset allocation decisions that lead to optimally constructed portfolios. We believe monitoring various cross-asset relationships, including foreign exchange, credit spreads, and real estate factors, over the remainder of 2024 will be critically important. With financial market volatility likely to ramp up, as often happens in a presidential election year, and with inflation data revealing whether we’re nearing the Fed’s anticipated rate cuts, we may see a declining trend in cross-asset correlations. These changing asset relationships are crucial in building diversified portfolios that are positioned to help meet investors’ risk and return goals.
