The prospect of US monetary tightening (see Cover, Shares 1 Aug) could herald the return of normal correlations between asset classes. Investors used to be able to count on an inverse relationship between bonds and equities to serve them well during bull markets, when equities were tearing away, and to protect their wealth in bear phases, when a flight to safety bolstered the capital value of bonds.

In the dislocated markets that followed Lehman Brothers filing for Chapter 11 bankruptcy (15 Sept ’08) investors discovered to their horror that, when diversification mattered most, almost all asset classes moved down as one. The policy response to the global recession which followed the financial crisis, namely quantitative easing (QE) chiefly in the form of government bond purchases, then resulted for a time in all asset valuations recovering in lockstep.

The Bank of England’s (BoE) Gilt purchases have sparked demand for equities as, in the Old Lady of Threadneedle Street’s own words, the private investors, pension funds and insurance companies from which it has been buying Gilts ‘typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares’. In fact, ‘do not want to hold’ should be replaced with ‘forced not to hold’ as the BoE’s buying has driven up Gilt prices, in turn depressing yields to levels unlikely to generate a real return above inflation. The 10-year benchmark Gilt yield bottomed at 1.47% last year (24 Jul ’12), three weeks after the BoE confirmed ‘QE-III’ (05 Jul ‘12).

Despite the initial recovery since the FTSE All-Share’s spring 2009 low (3 Mar ‘09) of 1,782, struck just two days before the BoE confirmed its first round of QE, or ‘QE-I’ (05 Mar ‘09), UK equities have since broadly traded sideways (barring this year’s tear), as have Gilt prices, as tracked by the FTSE Actuaries UK Conventional Gilts All Stocks Index. A 0.05 correlation coefficient between the benchmarks in the period July 2010 and June 2013 (see ‘Correlation coefficients 2’, below right) suggests only a weak positive correlation (see ‘Correlation coefficient explained,’ below). If, as the US Federal Reserve has signalled, QE may be on the way out, and should households, company profits and valuations be able to withstand the rise in borrowing costs to which the subsequent increase in government bond yields points, an inverse relationship between equities and bonds may be about to return. A -0.44 correlation coefficient between UK equities and Gilts which existed for the period July 2004 and June 2007 (see ‘Correlation coefficients 1’, below left) signifies such an inverse relationship.

Correlation coefficient explained*