Last year was unusual: U.S. equities and 10-year Treasuries both finished down, as heightened economic and geopolitical uncertainty and expectations for higher short-term rates drove markets. We see growth as the key market driver in 2019. This suggests Treasuries may offer more diversification benefits as a buffer to bouts of equity weakness.
The correlation between U.S. equity and U.S. government bond returns has been negative since the early 2000s, meaning the two asset classes generally move in opposite directions. Yet the magnitude of the negative correlation varies over time. It has recently turned more negative, as shown in the chart above. We see this relationship being sustained as economic growth becomes a key driver of market returns. One corollary: bonds may offer a more formidable ballast to equity exposures. These diversification benefits were particularly evident in December, a grueling month for risk assets: U.S. equities sold off by 9.2%, while 10-year U.S. Treasury yields fell below 2.7% from around 3%, sending 10-year Treasury prices up.
We see the correlation between equity and bond returns remaining significantly negative in 2019 as the economic cycle enters its latter stages. Growth, not Federal Reserve policy, is now the dominant market driver, in our view. A scenario where both U.S. stocks and 10-year Treasuries sell off, as in 2018, requires a big pickup in inflation leading to a more hawkish Fed. We see this as unlikely in 2019.
Fears of a sharp economic slowdown over the past couple of months have spurred a rally in U.S. Treasury prices and caused markets to dial down their expectations of potential Fed rate increases this year. Markets have moved from pricing in two 2019 Fed rate increases as of November to now flirting with the possibility of a rate cut. Yet market fears about economic weakness may have overshot, in our view. We see global growth slowing in 2019, and the U.S. economy entering a late-cycle phase, but view the risk of a recession this year as low. We see core inflation in the U.S. hovering near the Fed’s target, and the absence of meaningful inflationary pressures giving the Fed flexibility. We expect a pause in the Fed’s tightening cycle in the first half of 2019.
Against this backdrop, we maintain our neutral stance on U.S. government bonds. Increasing macro uncertainty is likely to stoke volatility in risk assets, pointing to the need for quality bonds when targeting portfolio resilience. We advocate flanking Treasury exposures with high-conviction allocations in areas that offer attractive compensation for risk, as part of our barbell approach for 2019. We would wait for a rise in yields before adding to U.S. government bond positions. One potential catalyst that could send U.S. yields higher in the short-term: an outcome from the latest U.S.-China trade negotiations that lowers trade tensions. Yet we see a full resolution of this trade dispute as unlikely in 2019 and, therefore, do not see a sustained rise in global yields this year. Also likely to suppress bond yields: We view the European Central Bank’s growth estimates as optimistic, and see a 2019 rate rise from the ECB as unlikely. We do, however, see yields gradually moving higher over the medium term as policy and the yield curve eventually normalize.