In this article, we discuss the unstable relationship between bonds and equities. Those more bullishly and hawkishly inclined subscribe to the narrative that fiscal stimulus and coronavirus (COVID-19) vaccines could facilitate earlier-than-expected normalisation of monetary policy. Tightening would be a sign of good growth and therefore a positive for the equity market from an earnings perspective and a negative for bonds. On the other hand, those more bearishly anddovishly inclined take the view that transition from a monetary stimulus-fueled model of growth to a regime where growth recovers organically with some fiscal policy support, could prove quite difficult and volatile given extended valuations everywhere. The claim therefore is that major asset classes cannot handle material increases in rates and volatility anytime soon, limiting how much normalisation can actually happen, and entrenching a positive correlation between bonds and equities.

We do not seek to resolve the tension here. We merely highlight that correlations are far from stable, and that investors need to hedge themselves accordingly. 

Our view is that economic recovery should offer greater support for value investors in early 2021. But investors also cannot afford to take their eyes off quality factors, given the tensions in asset allocation land, and the repercussions of seismic asset allocation shifts on the real economy. A blend of quality and value factors would put investors into selected energy exposures and real estate investment trusts (REITs).

Interestingly REITs seem to be facing an identity crisis much like equities. REIT investors are unsure whether the sector’s alpha is positively or negatively correlated with bonds, just as asset allocators are unsure whether equities are positively or negatively correlated with bonds. In our view, the two different sources of uncertainty cancel out for long-only investors, making REITs a very useful way of playing the re-opening thematic without having to worry about what might happen between bonds and equities. REITs are a powerful source of diversification and alpha.

Returning to the factor perspective, we note that REITs have shifted factor buckets. They used to screen well for quality because of low beta and high payout—but post-pandemic, they now screen exceptionally well for value. We do not know if or when REITs might revert to their old characteristics—but regardless of whether they do, they potentially offer the best of both worlds,as our factor screens and factor timing signals are suggesting.

In terms of specific stocks, our top-down views and analyst recommendations concur that DXS,VCX, GPT, SCG and CQR are worth considering as overweight exposures.