Is the negative stock bond correlation dead?

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A reliable negative correlation between stocks and core bonds has historically been a central tenet for portfolio construction, allowing investors to sleep easy through the trials and tribulations of the economic cycle.

In simple terms, a decline in economic growth would drag down corporate earnings and stock prices, causing central banks to cut interest rates in order to stimulate future growth, which in turn sends the price of bonds higher. As the economy and stock prices recover, central banks would raise rates, lowering bond prices. The beauty for investors is that if your stocks were doing badly, your core bonds were doing well, and vice-versa.

Over the past 18 months, the theory broke down. Last year the price of stocks and bonds fell in tandem. And this year they have both risen.

The reason behind the breakdown of this blissful synergy? Inflation.

The emergence of inflation means that central banks cannot support growth as their primary focus. In fact, they have to drive a downturn in growth rather than prevent it. Thus causing stocks to fall at the same time as core bonds.

We can see from the chart that the reliable negative correlation between stocks and bonds was only consistently present when central banks had inflation under control.

The question of whether the negative correlation returns therefore depends on the question I have focused on in past blogs. Will inflation quickly recede and not re-emerge in the future?

Regular readers will know that I’m sceptical in this regard. I believe that while headline inflation will fall further in the coming months, it will get sticky as it approaches the region of 3-4%. In the short term, central banks will not be able to cut rates and support growth as quickly as the market currently expects.

I also expect more frequent bouts of cost shocks, much like we experienced last year, in reaction to both more frequent climate events and a rocky transition to renewables as our primary source of energy.

I therefore expect the relationship between stocks and bonds to be less stable than it has been in the past, with periods of negative correlation but also significant periods of positive correlation.

For multi-asset investors, the key implication is that diversification is about more than bonds. Bonds will diversify a portfolio from a deep recession and deflationary shocks but we also need assets that will diversify against inflation shocks. For this we need to look towards alternatives. As we learned last year, assets like timber and core infrastructure provide true diversification against inflation shocks and should come under greater consideration from investors.??

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