At a time when the correlation between stock and bonds is at its highest level in years or even decades, the traditional equilibrium between these two asset classes could be put into question.

For years, investors have diversified their portfolios by adding assets with little or no correlation to stocks in order to protect themselves again stock market declines. Most of the time, a 50/50 balanced portfolio was used as the benchmark, with an assumed negative correlation between stocks and bonds. However, since 2021 and even more recently, the correlation between these two assets classes has increased considerably, even turning positive. These two asset classes now behave in a similar manner, signifying that they are no longer playing their role of diversification.

A history of correlation

Since the 1990s, stocks and bonds have moved in opposite directions, thereby offering greater stability for diversified portfolios, with bonds often serving as safe havens during episodes of weakness on the stock markets. However, in 2022, investors were surprised to see stock and bond prices fall simultaneously, indicating positive correlation between the two asset classes. After the 2008 crisis and the globalisation of the economy and in the absence of inflation, the central banks effectively revived the economy through massive injections of liquidities. The return of inflation at the end of 2021, reinforced by the war in Ukraine in 2022, marked the end of this monetary paradigm.

Source: Bloomberg and Mandarine Gestion

Under the weight of inflation approaching 10%, the Federal Reserve brutally lifted its key rates in order to combat the inflationary pressures. This led to declines in virtually all asset categories, with the exception of commodities. The following year, the majority of asset categories (except commodities) rose at the same time.

Source: Bloomberg and Mandarine Gestion

Such a simultaneous drop in stocks and bonds had not been seen since the 1970s and 1980s, which had been marked by high inflation and increases in interest rates. The correlation between these two asset classes has always been crucial for portfolio diversification given that they had been negatively correlated for an extended period of time.

Additionally, over the last ten years, the majority of asset categories have underperformed US stocks, notably due to better earnings growth momentum in this zone. The impact of Quantitative Easing was also significant in terms of flows and the relationship between risky assets. This situation has led investors to question the value of diversification. Nevertheless, this recent episode has been unique in nature. In the future, other asset classes should be able to offer significant advantages in terms of diversification and risk-adjusted returns comparable to those of equities. These asset classes should also offer yields higher than those of cash in order to compensate for the risks borne by investors compared to low-risk investments.

In an inflation-free context, a 50/50 balanced portfolio can offer a good risk/return ratio, as bonds partially offset declines in stock prices. However, if inflation rises, the two asset classes can fall simultaneously, reinforcing their correlation.

What consequences for investors?

The current macroeconomic trends suggest that the correlation between stocks and bonds could be more positive over the upcoming decade. The increased volatility of inflation and growth as well as the response of the central banks to persistently high inflation are the principal sources of risk in terms of increased correlation between stocks and bonds. A structural increase in the correlation between stocks and bonds would lead to structural erosion in the risk/reward ratio of a 50/50 balanced portfolio. In this case, it is important to diversify portfolios through the addition of other asset classes such as commodities, gold, real estate or solutions using absolute performance strategies.

Stocks and bonds: end of a winning combination?

Dernières Actualités