Will Positive Stock-Bond Correlations Fade Due To Sticky Inflation?
The recent persistence of sticky inflation risk suggests that positive stock-bond correlations of late could again turn negative.
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
The case for a “diversified” portfolio relies primarily on the complimentary relationship between stocks and bonds. While equities are expected to deliver the lion’s share of performance most of the time, bonds provide a hedge for those times when stock prices are falling. In the parlance of statistics, stocks and bonds exhibit low or negative return correlation.
That, at least, is the general view. But like many casual assumptions about financial markets, reality is more nuanced, especially over shorter-term periods. The caveat applies to correlations for stocks and bonds.
The diversification benefits of holding stocks and bonds endures, but the degree varies through time. There are periods when this form of diversification fades and we are in one of those periods currently.
Since mid-2022, the daily return correlation between stocks and bonds has been moderately positive, based on a pair of index funds (see chart below). That reflects a stark shift after roughly two decades of mostly negative correlations, based on rolling 200-day windows for daily returns.
The lesson is that correlations ebb and flow, which is to stay that the degree of diversification you receive from holding stocks and bonds is constantly in flux. Negative correlations align with stocks and bonds moving independently of each other, which can be helpful when one asset class is suffering.
To be fair, even a moderately positive correlation (as currently prevails) still offers diversification benefits. The latest 0.14 correlation is positive, but only slightly, which is to say it’s still a long way from approaching 1.0, or perfect positive correlation – a state that would, if it persisted, offer no diversification benefits.
The larger point is that diversification’s efficacy as a risk-management tool via stocks and bonds is far from static. Reflecting on this evolving relationship is timely for a couple of reasons. First, diversification generally is becoming harder to achieve at a time of globalized markets. Because money can easily move across borders and asset classes with the click of a computer mouse, the barriers have fallen that once kept markets relatively isolated (and correlations lower). In turn, investors are more inclined and able to move in lockstep at times as news and information circles the globe in a flash. There are still differences between asset classes and markets, of course, but those differences have generally narrowed. Diversification, as a result, has become more challenging to achieve.
But while diversification may no longer be as robust compared with decades past, it’s still available as a foundational tool for managing risk and boosting risk-adjusted performance. One thing that hasn’t changed: correlation still goes through cycles, mainly due to the changing nature of macro factors.
A key set of drivers: economic growth and inflation. A 2023 study in The Journal of Portfolio Management reports that the stock–bond correlation “depends not on the level of inflation, but on the relative volatility of growth and inflation and the correlation between them.” Meanwhile, “We have become accustomed to a negative correlation between stocks and bonds, but this was not the historical norm prior to the 2000s, with the average correlation positive in the 20th century,” write the authors of “A Changing Stock–Bond Correlation: Drivers and Implications” in the March 2023 issue of JPM.
Regardless of the explanation for changing correlation regimes, history is clear that the stock-bond correlation is dynamic. That empirical fact implies that the recent run of moderately positive correlations is probably a temporary phase. Why? Growth and inflation trends are in flux, which in turn influences correlation.
In the current climate, when the Federal Reserve appears to be increasingly focused on so-called sticky-inflation risk, a shift in the stock-bond correlation relationship may be approaching. This may turn out to be a significant issue if US economic growth remains relatively robust. In that scenario, there’s a possibility that the central bank will raise interest rates, which implies that the stock-bond correlation will decline, perhaps returning to negative terrain once again.
If correct, this outlook implies that bonds could suffer relative to stocks. Assuming stocks continue rallying, or least exhibit relative strength vs. bonds, this is a recipe for a lesser return correlation. This is also the basis for adjusting asset allocation and favoring inflation-indexed bonds in some degree vs. nominal bonds.
The market appears to be picking up on this assumption. For example, the iShares TIPS Bond ETF (TIP) is outperforming its near-equivalent Treasuries counterpart (IEF) so far this year through Feb. 14: 1.9% vs. 1.3%.
Perhaps, then, it’s no surprise that stock-bond correlations have recently fallen from the peaks of the last couple of years. The current 0.14 correlation is roughly half the level of the peaks in 2023 and 2024. If inflation remains sticky, even lower correlations may be approaching.
Read a pdf version of this article:
