Asset Allocation: Stock-Bond Correlation Flips as Growth, Inflation Diverge

Summary

• Strategies like the 60/40 portfolio gained in popularity due to the negative correlation between stocks and bonds. However, this is a more recent phenomenon as the correlation was positive before the 2000s.
• We find that the correlation between growth and inflation and the relative volatility between growth and inflation are important drivers of the stock-bond correlation.
• Only the energy sector offers substantial diversification when stock-bond correlations flip positive.
• If the Fed can keep inflation near its 2% mandate without needing significantly positive real rates, the negative stock: bond correlation will likely re-emerge.

Why the Stock-Bond Correlation Is Important

Modern multi-asset strategies like the 60/40 portfolio (60% stocks, 40% bonds) have been popular due to the negative correlation between stocks and bonds.

The rationale is that during periods of negative stock returns, the bond portion of the portfolio should perform positively, offering diversification, volatility reduction and income generation.

However, historical data reveals that a consistently negative correlation between stocks and bonds is a recent development, starting from the early 2000s. Before that, stocks and bonds tended to exhibit a positive correlation (Chart 1).

Fundamental Drivers of Stock and Bond Returns

We can break down the fundamental drivers of stock and bond returns into the following dimensions and attribute the likely impact on the asset.  

A higher inflation environment alone is not enough to increase the stock-bond correlation. The impact of inflation on profit margins plays a key role in driving stock returns.

Higher inflation generally implies stronger pricing power for companies. However, supply-driven inflation shocks that hinder growth and lead to rate hikes negatively impact both stocks and bonds, as monetary policy is forced to move countercyclically.

Additionally, the sector composition of an index can significantly affect equity performance. Indices with greater exposure to commodity-producing sectors like energy and materials tend to perform better in high-inflation environments.

To model the rolling three-year stock: bond correlation, we consider the following inputs based on the fundamental drivers of stock and bond returns:

• Rolling three-year correlation between growth and inflation.
• Rolling three-year volatility of growth versus inflation.
• Equity risk premium: the last 12 months’ earnings yield minus the 10-year Treasury yield.
• Three-month real interest rate.

We choose a three-year rolling correlation as it captures macroeconomic relationships that have a more significant impact on the stock: bond correlation over a longer timeframe. Shorter windows are noisier and more prone to influence from technical factors.

Our model explains 68% of the changes in the stock: bond correlation over time and has performed well during the post-2018 out-of-sample period, including capturing the shift in correlations observed last year (Chart 2).

What Caused the Stock-Bond Correlation to Flip Last Year?

By the end of 2021, inflation was already high, with headline inflation reaching 7% and core inflation at 5.5%. The conflict between Russia and Ukraine further impacted food and energy prices, worsening the situation.

• As inflation spiked, three-month real rates fell, which tends to be consistent with a more negative stock: bond correlation.

• Inflation volatility surged, accompanied by a negative effect on growth.

• This led to a decrease in the relative ratio between growth and inflation volatility and a weaker correlation.

• As the Federal Reserve accelerated rate hikes, the real three-month interest rate rose. This is significant because it occurred when real growth was slowing, causing interest rates to move countercyclically.

The combination of these factors resulted in both stocks and bonds falling last year, as correlations increased (Chart 3). Consequently, the 60/40 portfolio suffered its worst year in recent history.

The other ‘real world’ consequence of a sharp spike in interest rate expectations was that fixed income became a smaller portion within multi-asset portfolios so the fall in bond prices necessitated a selling of equities to rebalance. This meant some of the equity selling was likely mechanically as well as fundamentally driven.

How Do Equity Sector Correlations Compare?

Taking a more granular look within equities, we find that the stock: bond correlation shift of the early 2000s occurred more broadly across sectors.

Only utilities maintained its generally positive correlation with bonds due to its bond-like characteristics.

Last year, only the energy sector offered true diversification with a high negative correlation to fixed income, benefiting from increased oil and gas prices due to the conflict in Ukraine. We expect the energy sector to retain its unique role in equity portfolios due to its strong correlation with inflation.

Meanwhile, the tech sector’s correlation to bonds shifted significantly, following an increase of more than 0.4 points relative to the previous two years.

What Next for the Stock-Bond Relationship?

This year, we found that the rolling three-month stock: bond correlation turned negative again.

Headline inflation looks to be heading lower, and economic growth scares have been pushed back, supporting equities even as the Fed continues to hike.

The forward relationship depends on one’s view of the following questions:

1. Will the Fed need to exceed market expectations in hiking rates to tackle inflation amid slowing growth?
2. Are additional supply shocks probable, leading to a repetition of last year’s events?
3. In the long run, will the Fed uphold its credibility in managing inflation within the target set for its mandate?

In the short term, we think the Fed must hike higher than the market expects to curb inflation, which will pressure the stock-bond correlation over the next year.

Further out, if the Fed can keep the three-year annualised growth rate in inflation below 3% without needing significantly positive real rates, the negative correlation between stocks and bonds (over a three-year period) will likely re-emerge (Chart 4).

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Viresh Kanabar has worked in the UK financial services industry for over 8 years including in Consulting and Investment Risk. Most recently he launched The Macro Journal Substack where he puts out regular in-depth reports covering all areas of global macro.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)