The positive correlation between stocks and bonds has broken a 20-year trend of low-maintenance diversification. We argue this is not a cyclical anomaly, but rather the start of a new regime predicated on shifts in the macroeconomic and geopolitical environment. A secular shift in stock-bond correlation would represent a seismic disruption for traditional 60/40 portfolios, increasing volatility and uncertainty. We quantify the potential impacts and offer up potential paths to combating this new risk.
Key takeaways
- The correlation between stocks and bonds has been strongly positive over the past three years, abruptly ending a two-decade run of negative correlation.
- History suggests this relationship tends to move in long cycles which are driven by prevailing macroeconomic trends around inflation, government debt, and supply-side dynamics.
- A shift to positive correlation would make achieving investor goals more challenging by forcing a choice between higher risk and lower expected return. Fortunately, alternatives offer a potential ability to recapture some of that lost diversification.
Stock-bond correlation has entered a new regime
The relationship between stocks and bonds is an essential input for portfolio construction, meaning a shift in that relationship can have a massive impact on long-term investing goals. A negative correlation between the two asset classes benefitted the traditional 60/40 portfolio for 20 years, leading many investors to draw the conclusion that stocks and bonds are natural diversifiers. Indeed, many investors have never encountered a regime of positive stock-bond correlation (SBC). The past few years have wrought an abrupt end to this convenient period, with the three-year SBC rising above 0.6 for the first time in decades.
It is tempting to view this shift to a positive correlation as temporary and likely to revert. However, history shows periods of positive correlation are just as common as those of negative correlation. With the implications of a secular shift so significant, the topic deserves deeper discussion.
In this playbook, we shine a light on the nature of stock-bond correlation. This is a story of regimes defined by the macroeconomic backdrop. We look at regime characteristics, crucial macro drivers, and quantify the impact of a higher SBC traditional 60/40 portfolio. Investors have been slow to grasp the implications of the new regime on the 60/40 portfolio. Understanding how to re-introduce diversification into portfolios using alternatives is a long-run imperative, in our view.