In the second half of 2014, European equities were being sold off as markets were in the grip of a correction. At the same time, net inflows into supposedly low-risk investment-grade bonds were at record high levels. In December, as rumours about the imminent launch of QE by the European Central Bank grew more intense, equity markets started to rally, and the negative correlation between equity and bond flows started to fade.
By January, the correlation between the two investment categories had reversed from negative to clearly positive. So far this year, correlation between investment-grade bonds and European equities stands at 0.81. The average correlation between developed market government and corporate bond flows and European equity flows has been -0.06 (meaning there has been no correlation at all), so this is quite a significant change.
David Vickers, multi-asset portfolio manager at Russell Investments in London, believes equities and bonds have started to correlate so much because many investors are essentially invested in these asset classes for the same reasons.
“These days, many people are in equities because they think interest rates will stay low,” he says. When rates eventually go up, it means the risk-free rate will too. If interests rates will go up quicker than implied now, this needs to be compensated by higher than expected earnings growth to justify valuations, Vickers argues.