By Robin Marshall, Fixed Income and Multi-Asset, Global Investment Research
The historically low correlation between equity and government bond returns is a cornerstone of modern investment strategy and the traditional 60%/40% model portfolio, based on the theory this split provides diversification benefits that can improve risk-adjusted returns over time. For most of the past tumultuous year, however, stocks and bonds have moved in virtual lockstep, undermining faith in the long-term efficacy of this classic framework.
The chart below plots the 12-month-rolling correlation coefficient between the FTSE Global All-World equity index and the FTSE World Government Bond Index (WGBI) since 2013. As shown, the relationship has been far from stable. Most of the time, stocks and bonds tended to show a low positive correlation, with a mean of 0.29. There were two episodes of negative correlation over this period: in 2015-2016 and in 2020. Over the past year, however, it has grown sharply positive, breaching 0.8 this February, and now standing at a 10-year peak of 0.86 at March-end – a particularly distressing trend given the epic downturns in both assets during the period.
Correlation of returns – FTSE Global All-World Index and FTSE World Government Bond Index
Source: FTSE Russell / Refinitiv. Data through March 31, 2023. Past performance is no guarantee to future results. Please see the end for important disclosures.
Correlation shifts with the policy backdrop and risk appetite
Several insights emerge from this 10-year history. Though generally positive over the past decade, the correlation between the two has surged most dramatically during bouts of high market anxiety, triggered by impending pivots to more restrictive monetary policies. This occurred during the Taper Tantrum in 2013, at the start of the Fed tightening regime in December 2015 and as the post-lockdown inflation shock emerged, followed by the global rate-hiking cycle from 2021 to the present – all of which drove steep declines in both asset classes. The only exception was the period immediately following the Covid outbreak when the G7 central banks unleashed QE asset purchases and slashed rates to zero, and both asset classes performed well together.
Decoupling during growth and deflationary shocks
There have been two significant (albeit brief) negative turns in the stock-bond correlation of returns over the past decade, both following macroeconomic or deflationary shocks and bursts of extreme risk aversion. The first occurred during the collapse in oil and commodity prices and the Chinese devaluation and growth scare in 2015-16, and the second in the early months of the Covid-19 outbreak.
The correlation also fell sharply in reaction to Russia’s invasion of Ukraine, when unnerved investors briefly flocked to safer assets, including government bonds, and away from riskier stocks. But once the Federal Reserve began tightening monetary policy, from March 2022 onwards, the correlation rebounded strongly, with equities and government bonds tumbling or rising together.
A possible threat to the traditional 60/40 portfolio construction...
As this history illustrates, the 60/40 model has generally been most effective during deflationary shocks, when yields on government bonds moved sharply lower, countering the negative effects of risk-off sentiment and reduced earnings growth expectations on equity valuations. The recent global banking woes also caused a sharp drop in the correlation of stock and bond returns, confirming that government bonds work best as diversifiers when their safe-haven characteristics come into play, just as they did during the early days of the Global Financial Crisis before central banks unleashed QE asset purchases and pushed rates to zero or lower.
...but an inflationary regime shift would be an even bigger danger
That said, the 2022-2023 positive spike in the stock-bond correlation raises the significance of whether the recent bout of higher inflation will ultimately prove short-lived or heralds a longer-lasting regime shift. Under the latter scenario, the stock-bond performance harmony that has wreaked havoc on the traditional 60/40 portfolio for the past year may persist. Investors with long memories will recall that the high inflation of the 1970s and early 1980s coincided with a protracted stretch of negative performance for both equities and government bonds, which is why the future path of inflation is so important.
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