Shifting correlations amid spikes in volatility

Since the pandemic, investors have seen volatility spike and correlations shift quickly and unexpectedly. These phenomena have upended traditional assumptions about volatility and correlation, albeit for different reasons.

From the late 1990s until 2020, stocks and government bonds were negatively correlated, allowing diversified portfolios to use both asset types, at different times, to seek returns and for hedging purposes—in other words, to play offense and defense. However, over a longer period, the stock-bond relationship has not always been negative. Stocks and bonds were positively correlated from the early 1960s to the late 1990s, a period of elevated inflation, monetary policy uncertainty and a multi-polar world.

Then came the 20-plus years of negative correlation, until the pandemic. In the wake of the unprecedented fiscal and monetary stimulus enacted during the pandemic, 2022 saw a sharp spike in inflation. Not only did market volatility soar but stock-bond correlation turned positive (Exhibit 1), leading 60/40 stock-bond portfolios to decline 16% in 2022, the worst return since 2008.

The Trump Administration has pursued an aggressive trade, immigration and fiscal agenda, leading investors to question how these policies will interact. Market participants have been concerned that tariffs, combined with more limited labor supply, could put upward pressure on inflation, which could be exacerbated as fiscal stimulus hits the economy in 2026. The result has been a sharp spike in volatility and unstable stock-bond correlation.

Some investors and politicians have questioned why the Federal Reserve has paused easing interest rates and called for a pickup in both the pace and magnitude of rate cuts. Uncertainty about the trajectory of monetary policy has pushed stock-bond correlations into positive territory for most of 2025 to date.

Fiscal activism and economic nationalism

Volatility and correlation are symptoms of a shifting environment. For investors, it’s essential to understand the causes underlying the changes in the relevant variables. Rising volatility fundamentally reflects a wider range of potential outcomes, and less confidence in the direction of travel; these have both been exaggerated by this year’s policy developments.

Our 2025 Long Term Capital Market Assumptions (LTCMAs) explored the themes of economic nationalism, fiscal activism and higher macroeconomic volatility, suggesting that over the next 10 to 15 years, investors would see more active fiscal policy focused on domestic economies. This would in turn lead to broader policy volatility (particularly fiscal) and a less stable inflation environment.

We expect the ongoing trend of fiscal activism to continue, despite high government debt levels and rising demands for government capital and day-to-day spending—particularly for an aging population. However, from an investor perspective, fiscal investments must appeal to international buyers of U.S. government bonds, to ensure funding at reasonable interest rates.

While we expect better balance between monetary and fiscal policy to contribute to higher nominal growth over the coming business cycle, that balance will also likely result in higher interest rates – and higher interest rate volatility – compared with the post global financial crisis (GFC) period. That will be particularly true if bond market investors begin to act as “vigilantes” looking to restrain fiscal spending.

We will be keeping a close eye on bond market volatility. At the same time, it will be key to monitor the dynamic of higher government spending on the domestic economy. In this context, we note that the rise of economic nationalism can cut both ways: While it contributes to a more fragmented global trading environment (it does not equate to deglobalization), if domestic spending is focused on strategic planning and resilience, it could enhance productive capacity over time.

However, if economic nationalism veers into protectionism, it risks stimulating inflation and interest rate volatility, thereby disrupting the capital markets. Its impact on economic growth hinges on implementation. Strategic initiatives that address gaps and enhance resilience can bolster growth. On the other hand, protectionist measures may lead to inefficiencies and inflation spikes.

Diversifying the diversifiers

Persistent fiscal activism and economic nationalism, reflected in higher inflation volatility, underscore the importance of holding inflation-geared assets within a balanced portfolio. And, as noted, higher macroeconomic volatility will potentially leave stock-bond correlation less stable. Portfolios will need assets which can offer resilience against inflation and holdings that can provide diversification against positive stock-bond correlation.

Real assets can provide both attributes. Private real estate and infrastructure have historically been uncorrelated with a 60/40 stock-bond portfolio while generating inflation-linked cash flows. Private U.S. real estate valuations remain attractive, presenting compelling opportunities vs. U.S. public market assets.

Certain types of hedge funds, such as market neutral and macro strategies, can act as diversifiers within a broader portfolio. Although hedge fund returns have been lackluster since the GFC, today’s economic nationalism and fiscal activism should lead to higher rates and capital market volatility, in turn creating a more supportive environment for hedge fund performance.

Investment implications

We continue to position our multi-asset portfolios with a modestly pro-risk tilt. Fiscal activism and economic nationalism potentially present two-sided risks for equities: on the upside, from productivity gains and deregulation; on the downside, risks from higher tariffs. We have targeted equity overweights (including info tech, communication services and financials), although valuation is a concern, particularly for the S&P 500. We expect the U.S. economy's resilience and the artificial intelligence theme to persist. We also favor Japan, Hong Kong, UK and, increasingly, EU equities with fiscal stimulus anticipated in 2026.

Our slight overweight in global duration is justified by cooling labor markets and more trend-like economic growth. We prefer long positions in U.K. Gilts and Italian BTPs, which offer higher carry and more positively sloped yield curves than U.S. bonds. In the U.S., our focus is on the front end of the curve. As credit spreads have tightened, our portfolios have gradually shifted towards a more neutral stance in credit, although we still see attractive carry opportunities, particularly in U.S. high yield. Strong company balance sheets and a diminishing risk of recession support this strategy.

In FX markets, we anticipate further USD weakening against the euro amid euro-area growth, more robust fiscal spending and the European Central Bank’s rate cut pause. We see marginal demand for USD declining as the U.S. aims to narrow its trade deficit. Our portfolios underweight the Japanese yen due to moderating economic activity and the punitive cost of carry.

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