By Daniel McGarvey, Portfolio Analyst, on behalf of Stonebridge Financial Group advisors
Investors traditionally expect bonds to provide diversification benefits to a portfolio of equities, especially in times of heightened uncertainty where stocks fall off. In more technical terms, they expect a negative stock-bond correlation, which allows the two asset classes to act as hedges for each other. However, 2022 was infamous for having the worst year ever for bonds at the same time as a substantial equity drawdown, proving that their correlation is not immutable and is heavily influenced by macroeconomic factors.
Inflation shocks, for example, are associated with higher stock-bond correlations and have contributed to the rolling figure turning positive after spending decades in negative territory (see chart below).
Another important takeaway from this chart is that, despite the common perception that the stock-bond correlation should typically be negative, it was positive for decades and can spend significant periods of time in one regime or the other. A persistent positive regime would not by itself compromise the long-term return expectations for a balanced portfolio, but it could result in modestly higher volatility since the portfolio is essentially less hedged. One way to help mitigate the increased volatility with this higher correlation is to overweight shorter duration, which has been our preference in fixed-income portfolios this year.
In general, we would not be surprised to see an increase in volatility in the coming months, given the uncertainty regarding where our economy is headed and how the Federal Reserve will respond. Somewhat counterintuitively, in this environment, positive economic data could be
bad for stocks and bonds because they stir rate hike concerns, and the opposite could be true as well. It remains to be seen whether the Fed will be able to engineer a soft landing successfully, but some cracks are forming, and upcoming policy decisions will affect whether stock-bond correlations continue their trajectory or go negative again.
August was one of the weaker months of the year for stocks, with the S&P 500 returning -1.6%. The Bloomberg US Aggregate Bond Index also had negative returns of -0.6% as the 10-Year Treasury rate rose as high as 4.3% before ending at 4.1%. As of the end of August, the market expects the Fed to hold rates steady until cutting in May, indicating that if a recession does come, it could be several quarters away.
Charts provided by YCharts, Inc. and Strategas Research Partners LLC.
Material discussed is meant for general/informational purposes only, and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary, therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.