Correlations between Asset Classes

Fungibility of money is central to the process of investing & wealth creation. It implies equal value between the assets & facilitates substitution of an asset class by another. The investor chooses an investment with most favorable risk-reward ratio but is free to substitute it with another when such ratio turns unfavorable. The primary investment options – commodity, bond, equity & currency – have deep correlations. Whatever happens in one asset class has an impact on fundamentals of other asset classes. The intermarket relationships assume critical importance for the investor, as he tries to figure out the big picture & assess the shifts in the direction for each asset class.

Bond

Reserve Bank of India (RBI) issues bond to finance government expenditure & the coupon rate at which it issues its 10-year paper, is the primary benchmark from which all interest rates in the economy are derived. Bond Yield is actual return if an investor was to buy bond from the market. It is calculated as % of interest earned by investor (interest rate % on face value) & bond market price. Bond price & bond yield move in opposing direction. There exists an inverse relationship between interest rate & yield.

Bond Yield is influenced by

• Interest rate expectations – Important indicators are RBI’s view on the state of economy & real time data on economy.
• Inflation – Inflationary environment forces investor towards higher yield – to compensate for loss of purchasing power.
• Economic Growth – Strong economic growth forces competition for capital, thereby pushing up the yields 

Equity is a riskier asset & risk needs to be compensated by a premium over & above interest rate in the economy (as derived from the most risk-free coupon rate of RBI).

Equity

Investment decisions are based on risk-return trade off. Equity is a riskier asset class than debt. If interest rate on FDs is 5% & expectation from equity is 9 to12%, then one would be more inclined to invest in equity, even if it means taking more risk.

As bond yields fall, equity becomes more attractive asset class. The reasons for fall are 3-fold. Firstly, due to shift in asset allocation from bonds to equity by aggressive investors. With more money flowing into equity market, stock prices rise further & investors get higher returns. Secondly, decline in interest rates result in lower borrowing costs for companies & an improvement in profit (EPS). Thirdly, companies take advantage of lower interest cost to fund capital expenditure & growth, thereby generating expectation of higher profits in future. The combined effect is higher demand & a fillip to equity valuations.

When yields start to rise, bonds become more attractive in a relative sense. As long as gap between expected equity return & bond yield does not get too narrow, there is no reason to shift asset allocation to bonds. Also, if interest rate is raised by RBI on account of demand side inflation (due to faster economic growth & higher per capita income), then companies have the power to pass inflation onto customers & protect (even improve) profits. In such case, equity remains the preferred option.

When bond yield keeps rising, an inflexion point is reached where risk free yield makes expected return from equity unworthy of the risk in it. At such point, investors begin shifting asset allocation from equity to bond. The resultant selling in stocks & demand for bonds leads to simultaneous fall in stock prices as well as bond yield. As stock prices fall, risk-averse investors begin shifting to bond to protect their capital, causing stock prices to fall further along with fall in bond yields.

Eventually, stock prices would have fallen so much that expected reward from equity starts looking attractive vis-à-vis bond yields. The shift in asset allocation to equity begins all over again.

Currency

Exchange rate vis-à-vis Reserve Currency (US Dollar) impacts fund flows to & from all markets. Commodities are directly impacted by depreciating or appreciating currency. Imports in depreciating currency environment translates into higher inflation & cost of production. Rise in CPI inflation forces RBI to hike repo rates – the most important factor effecting bond yields.

Foreign institutional investors (FII) want dollar (USD) returns. US Treasury Bond Yield is the reference point for investment decisions of FIIs. ‘Interest rate differential’ with Gilt bond yield, net of expected currency depreciation would be the key parameter. Inflows & outflows of USD would impact the exchange rate.

If US Treasury Bond yield rise & the INR depreciates versus USD, then risk-reward ratio for ‘Indian equity vs. US Treasury bond’ gets less favorable. FII flows into / from equity market impact our bond yields indirectly through the foreign exchange rate.

Commodity

As commodity prices rise, the cost of goods moves upward & the price increase gets passed onto the consumer.

The inflationary impact of commodity price rise is further accentuated by currency depreciation, in case the commodity has to be imported. For example, India’s 80% oil demand is met through imports & depreciation of INR visa-vis USD tops up the inflationary impact of oil price rise. Inflation ultimately gets reflected in interest rates.

Intermarket Relationships

All the four markets operate together but there is always a time lag between each of the market reactions. Also, several factors may come into play during such time lag. An understanding of positive & inverse correlation among the markets, provides important confirmation of developing trends & warnings of potential reversal.

If commodities are rising, bonds have started to fall & shares are still on the rise, then the inter-relationships would eventually force a retreat in stocks at some point. It is just a warning of a reversal for stocks. A confirmation that correlations are taking over would only come when share price goes below major support levels & moving averages.

At times, intermarket relationships break down. The above correlations assume an inflationary economic environment. However, in a deflationary environment, share prices go down on account of poor growth prospects but bond prices will move up to reflect lower interest rates. Despite the economic environment, one market may not respond at all due to shifting global dynamics, like financial liquidity, politics etc.