We expect stock/bond correlations to be less reliable in the coming years, mainly because we think inflation volatility will be higher.

Negative correlation between stock and bond prices has been a key pillar of portfolio construction for much of the past two decades. The resurgence of inflation flipped this relationship in 2022, with both bonds and equities losing ground as the market priced in higher policy rates to deal with ongoing price pressures. While inflation has declined substantially this year, stock/bond correlations have remained stubbornly positive, creating challenges for investors looking to build diversified portfolios.

Looking ahead, we do expect the stock-bond correlation to return to negative territory in our base case scenario for the economy next year. We see weaker growth ultimately bringing inflation much closer to target, which in turn should eventually create room for central banks to cut rates to support the economy.

While this outcome would make diversification easier to come by in 2024, it’s also important to note that we anticipate more volatility in the stock/bond correlation in the coming years, mainly because we think inflation volatility will also remain higher in the medium term.

Climate change is already leading to more food price volatility, with the summer droughts in India one of several recent examples. The pace of the energy transition is likely to receive greater attention as a result, yet despite many wind and solar sources now being cheaper than fossil fuel equivalents, significant price swings are still likely given the intermittency of renewable power. Meanwhile, the role that US suppliers have played in oil markets over the past decade to dampen price volatility – by increasing production as prices rose and vice versa – is no longer as prominent.

All of these shifts seem likely to increase inflation volatility, and therefore the unpredictability of the stock/bond correlation.

For investors, a less uniformly negative stock/bond correlation reinforces the need to use different assets to diversify against different risks. Fixed income will still be the key tool to diversify against disinflationary recessions, when central banks are able to ride to the rescue. But when it’s too much inflation that’s the worry, rather than too little growth, a broader toolkit of diversifiers will be required.

We therefore see an increased role in portfolios for real assets, such as private infrastructure and timber. These asset classes historically have exhibited a low correlation to traditional assets, as 2022 demonstrated, and thus can often diversify against the inflation shocks that lead to periods of positive stock/bond correlation.

For investors that don’t have access to private market vehicles, other diversifiers are on offer. Some public market alternatives – for example, real estate investment trusts – have disappointed recently as rising yields have resulted in equity-like volatility. But commodity strategies and hedge funds (which often benefit from higher levels of market volatility) could also help protect portfolios when both stocks and bonds are falling.


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