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Bonds may play a renewed role in portfolios – are you ready?

When the January U.S. CPI print came in higher than investors expected, both stocks and bonds sold off on the news. It was yet another instance of positive—that is to say, unfavorable—correlation, in which stock prices and bond prices move in the same direction. This environment has prevailed since the COVID shock of 2020. But we think the favorable negative stock-bond correlation will return in the coming years as inflation stays under control.

Stock-bond correlation may seem like an arcane subject, but it can have a significant impact on your investment decisions. Negative stock-bond correlation, when stock and bond prices move in opposite directions, means that bonds can once again play their traditional role in a multi-asset portfolio by potentially hedging against weak economic growth and mitigating stock market volatility. Put differently, negative stock-bond correlation strengthens portfolio diversification and gives you better potential opportunities to meet your long-term investment goals.

Inflation is the key variable to watch. While bonds can hedge against growth shocks, they cannot protect against unexpected inflation shocks. The January U.S. CPI print notwithstanding, we believe inflation is moving steadily lower. Central banks have successfully anchored inflation and inflation expectations, in our view. Thus we feel confident forecasting the return of negative stock-bond correlation.

Historical links between inflation and stock-bond correlation

The history of stock-bond correlation is instructive (see chart below). Looking at data back to 1940, we find clear links between inflation and this important correlation. 

After 20 years of favorable stock-bond correlation, it flipped during the recent inflation shock

Rolling 5-year correlation between changes in P/E multiples and changes in 10-year Treasury bond prices

The chart describes rolling 5-year correlation between changes in P/E multiples and changes in 10-year Treasury bond prices.
Sources: S&P, Robert Shiller. Data as of September 30, 2023. Positive correlation: when stocks and bonds move in the same direction. Negative correlation: when stocks and bonds move in different directions.

In the late 1960s, inflation began to rise in the context of an overheated economy and a ramp-up in defense spending related to the Vietnam War. Then, in the 1970s, the U.S. economy was hit by a major supply-side shock connected to the 1973 oil embargo. Oil-producing countries in the Middle East restricted oil supplies to the United States in the wake of its support of Israel during the Yom Kippur War. Oil prices more than tripled, sending inflation spiraling even higher. It was in this environment that stocks and bonds began to move in the same direction.1

Inflation persisted at painfully high rates for years. In addition, inflation expectations became completely “unanchored” in the 1970s, meaning, essentially, that households and businesses had little faith inflation would ever retreat to the modest levels of the first half of the 1960s.

Federal Reserve (Fed) Chair Paul Volcker famously crushed inflation at the end of the 1970s. A series of historic and aggressive policy rate hikes, known as the “Volcker shock,” sent the economy into a deep recession, but in the end, it did kill inflation.

The Fed moved toward an inflation-targeting regime, but it wasn’t until the 1990s that low inflation expectations finally became anchored, and that is precisely when the negative stock-bond correlation re-emerged. That favorable negative correlation lasted for about 20 years in the lead-up to the COVID global pandemic.

Pandemic inflation and rapid rate hikes

We all know the next chapter: The pandemic scrambled the global economy, and inflation followed in the context of major fiscal stimulus and monetary easing. Then in 2022, the Fed had to reverse course and institute the fastest and most aggressive monetary tightening since the Volcker shock. All of this was bad news for the stock-bond correlation, which turned positive and remains so at the start of 2024.

To be sure, in 2020 and 2021, investors didn’t mind positive stock-bond correlation, given that stock and bond prices were rising together in those years. However, in 2022, investors were reminded how painful positive stock-bond correlation can be, as stocks fell by about 25% in that year (peak to trough) and Treasury bonds dropped by about 17%.

The return of favorable (negative) stock-bond correlation

Investors may wonder why we expect negative stock-bond correlation to re-emerge. After all, over the long term, the correlation is more often positive than negative. Considering data back to 1940, a negative stock-bond correlation persisted only 38% of the time.

We expect the return of negative stock-bond correlation for one reason above all: The rapid rate hikes of 2022–23 proved that central banks are committed to anchoring inflation and inflation expectations. What’s more, they are finally seeing that inflation is moving toward their 2% target. In addition, inflation expectations, especially short-term expectations, have come down meaningfully from the very worrisome levels that persisted in 2021 and 2022 (see chart below). As the historical data shows, favorable negative stock-bond correlation is closely linked to relatively low and anchored inflation.

Short-term inflation expectations have declined dramatically from their 2022 peak

Expected rate of inflation, year-over-year % change

The chart describes the one-year ahead and 10-year ahead expected inflation in %.
Sources: Federal Reserve Bank of New York, Federal Reserve Bank of Cleveland, Haver Analytics. Data as of January 31, 2024.

No one can predict precisely what level of inflation will cause stock-bond correlation to flip. In our view, the level is around 3%, meaning inflation rates below 3% will likely enable the return of favorable negative stock-bond correlation.

To put this in context: Inflation captures people’s attention in a nonlinear fashion. When it falls below some threshold, the general public and market participants do not perceive it to be a problem. But once inflation rises above that threshold, it quickly becomes alarming—and often a dominant factor in market performance.

We illustrate how important the 3% threshold is in the chart below, which plots equity market price-earnings multiples against inflation. The fit line is distinctly nonlinear. In other words, equity market multiples are typically high and stable when inflation is below a threshold of close to 3%, but multiples deteriorate rapidly once the threshold is crossed. Historically, when inflation was below 3%, the average equity multiple was 22.8x versus 14.9x when inflation was above 3%.

Historical data shows a nonlinear relationship between equity multiples and inflation

S&P 500 P/E multiple

The chart is a scatterplot that shows the nonlinear relationship between equity multiples and inflation.
Sources: S&P and Atlanta Federal Reserve. Data as of September 30, 2023. Chart note: The Atlanta Fed’s measure of Sticky CPI is used rather than overall CPI because the trend fit is better with Sticky CPI. The S&P 500 multiple considered is price per share relative to an HP-filtered smooth trend of operating earnings per share. The data considered is quarterly running from Q1 1965 to Q3 2023, and inflation observations less than 2% are excluded.

Real assets can hedge against resurgent inflation

We believe inflation is set to remain below 3% for the coming years. However, we acknowledge risks to our view. Inflation could reaccelerate, perhaps in the wake of an unexpected geopolitical shock. If inflation doesn’t stay below 3%, then bonds will likely fail to act as a buffer in multi-asset portfolios.

If consumer prices take off again, investors can find potential inflation defense in real assets, or the more “real asset-like” sectors of the equity markets. The chart below shows how real asset sectors tend to perform well as a “hedge” when inflation accelerates. 

Real Estate, Materials and Energy tend to be good inflation hedges

PCE Chain Price Index, YoY % change (LHS); YoY % change (RHS)

The chart describes the year-over-year % change of PCE inflation as well as the year-over-year % change of the real estate + materials + energy market cap as % share of S&P 500.
Sources: Bureau of Economic Analysis, Standard & Poor’s, Haver Analytics. Data as of December 31, 2023. Past performance is not indicative of future results. It is not possible to invest directly in an index.
While inflation rates may not move lower in a straight line (as the January CPI print reminded us), we do expect to see U.S. inflation at or below the critical 3% threshold for the foreseeable future. In our view, this will likely pave the way for the return of favorable negative stock-bond correlation and strengthen the potential for portfolio diversification.
1Source: S&P, Robert Shiller. Data as of September 30, 2023.
Inflation is moving steadily lower, paving the way for the return of favorable negative stock-bond correlation.

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