Where next for the equity-bond correlation?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below. 

All data referenced in this article is sourced from LSEG Datastream unless otherwise stated, and is accurate at the time of publishing.

Key points

• Traditional 60/40 portfolios of equities and bonds have been less effective at diversifying portfolios in recent years, as the performance of both assets moved more in sync.
• The spike in inflation in 2022 was a powerful driver of the more positive relationship seen between the returns of both asset classes. As price increases have abated in the last six months, the dynamics have turned for the better.
• However, the world has entered a more uncertain era as the US follows more assertive geopolitics. This could cause inflation to rise again.
• With the relationship of equities and bonds still in flux, investors might need to find new sources of diversification to manage portfolio risk.

Investors have long invested in bonds and equities as a way of reducing portfolio volatility through diversification: the two typically reacting differently to similar economic conditions. In other words, the two asset classes were negatively correlated. But this relationship appears to have broken down of late. 

Since the turn of the century, negative equity-bond correlations survived several macro and bear-market regimes. A negative equity-bond correlation implies that bonds can bring balance to a portfolio, by mitigating the effects of equity drawdowns.

However, the relationship flipped in 2022, amid soaring inflation and higher interest rates. A positive equity-bond correlation has persisted since. So, what are the main drivers of this relationship, how long might the trend last, and what could this mean for portfolio asset allocation?

Macro drivers of equity-bond correlation

Historically, bonds have tended to outperform, relative to their long-term average, when inflation is slowing (disinflation) or prices are falling (deflation). Meanwhile, equities favour reflation and disinflation. This is because bonds usually react positively (negatively) to falling (rising) inflation, which is likely to result in lower (higher) interest rates. 

Equities are usually boosted by monetary and fiscal stimuli during reflationary episodes. They also generally outperform when prices are rising at a slower pace, which should aid future profits and reduce discount rates. However, deflationary periods are associated with equity underperformance, such periods often coinciding with recessions and much more uncertainty. 

Moreover, when considering times of inflation and economic growth, then equity-bond and inflation-growth correlations tend to move in opposite directions. As such, equity-bond correlations can be expected to increase, when inflation is out of sync with the growth cycle. As seen in 2022, both asset classes frequently suffer losses in stagflationary regimes.

What happens when equity-bond correlations spike?

When the equity-bond correlation is positive, the benefits of diversification are weaker, as bonds provide less protection during periods of turmoil in equity markets. Assuming that an investor’s risk tolerance remains the same, when the correlation flips from negative to positive, the optimal asset allocation should shift too, so as to remain in the pre-defined risk budget. 

Equity and bond markets had long periods of either positive or negative correlations between each other when inflation was moderate, at 2-3%. However, when inflation rocketed higher in 2021 and 2022, the diversification effects faded (see chart). In periods of excessive inflation (say higher than 5%) the equity-bond correlation was always positive, implying low, or no, diversification contribution from bonds.

US equity-bond correlation versus inflation

The relationship between the three-year rolling correlation for US equity and government bond monthly returns and the annualised rolling three-year consumer price index since 1965

The return of inflation

The pandemic-induced inflation surge in 2022 marked the first time that US equity and bond returns had both fallen since 1972, thus diminishing the ‘safe-haven’ properties of government bonds.

The next chart highlights the unprecedented rise in the equity-bond correlation seen since 2022. Consequently, a portfolio comprising 60% US equities and 40% US government bonds performed poorly that year, approximately in line with that seen in the burst of the dot-com bubble in the early 2000s and the oil price shock in 1974.

The dynamics of US equity-bond correlations

The trend in three- and ten-year year rolling correlations of equity and bond monthly returns since 1965

Is the inflation scare over?

Our analysis of equity and bond returns indicates that elevated inflation and monetary policy uncertainty, coupled with a more closely correlated term and equity premium, were the main drivers of the spike in the equity-bond correlation in 2022 (see chart). However, due to the subsequent receding inflationary pressures and interest rate cuts, the realised rolling three-year equity-bond correlation has fallen from its July 2024 peak.

The drivers of equity-bond correlation

The changes in realised equity-bond correlation (RHS) and its breakdown into key components for each calendar year from 2021 

This suggests that bonds are slowly regaining their reputation as portfolio diversifiers. If inflation continues its convergence toward the central bank target, and this is accompanied by gradual interest rate cuts, the equity-bond correlation will likely slide as well.

Whether this trend persists in the short-to-medium term, depends primarily on global growth and trade dynamics. Indeed, the wave of geopolitical tensions seen this year, coupled with elevated equity market valuations and extreme concentration of technology stocks in the US market, could tilt equity-bond correlations in either direction. 

In a scenario where tariff wars spread, and intensify, negative supply shocks could hit global growth forecasts, potentially sparking another inflationary burst and cutting output. In turn, equity-bond correlations would likely push higher, and weaken the performance of 60/40 portfolios. 

Geopolitics in tension

The key challenge stems from periods of elevated inflation often coinciding with heightened monetary policy uncertainty, which then affect future inflation and economic growth too. This may be further complicated if economic and geopolitical shocks occur at the same time, which can lead to negative feedback loops among economic variables.

However, it is important to recognise that this scenario seems highly unlikely, from a historical perspective (although history is no guarantee of future outcomes). It would assume a sea-change in international relations and a series of negative ripple effects. 

If these risks do not spiral out of control, inflation and growth will likely remain immune to geopolitical headlines, and be primarily driven by fundamental economic forces over the medium and long term.

Diversification to the rescue

The traditional link between the performance of equities and bonds is in a state of flux. In terms of the implications for diversifying investor portfolios, it remains unclear whether the equity-bond correlation has reached its post-pandemic peak. Recent changes in the macroeconomic landscape leave room for optimism, however, persistent elevated uncertainty calls for a cautious approach. 

For investors, this might mean finding other sources of diversification. Especially if looming geopolitical risks materialise and bring stagflationary concerns to the fore once again.