Where to Go With Positive Stock/Bond Correlations

joseph burnsIn periods of positive stock/bond correlations, the case for diversified sources of return is much clearer. With stocks and bonds now showing their strongest positive correlation in almost 30 years, the natural diversification and risk protection that a traditional 60/40 portfolio offers is open to question. Meeting this challenge will require access to assets that are less dependent on the direction of the overall market, potentially via alternative investments such as direct lending, real estate debt, and macro hedge funds.

When looking at global capital markets over the last 50 years, one of the main observations is the changing correlation between stocks and bonds. Some periods show sustained positive correlation, while at other times it is negative. Over any extended period of time, we know the way that assets react to fundamental economic measures will change. Yet a core tenet of any investment framework is an enduring relationship between stocks and bonds.

This relationship between stock and bonds is a primary factor for assessing risk in an investor’s portfolio. In periods of negative correlation, investors can rely on the bond portion of their portfolio to function as a counterweight to equities. For example, when equity markets experience a decline, bonds would provide natural protection, and vice versa.

traditional 6040

In fact, over much of the last 20 years, stocks and bonds were negatively correlated — providing the desired backdrop for an effective traditional 60/40 portfolio. But starting in 2018, the degree of negative correlation began to turn and, importantly, the diversification protection that bonds provided began to deteriorate. Stock/bond correlations turned positive in early 2022 (based on trailing 24-month returns), suggesting that stocks and bonds are now more likely to experience similar directional moves.