In our recently published2024 Diversification Landscapereport, Christine Benz, Karen Zaya, and I took a deep dive into how different asset classes performed in the past couple of years, how correlations* have evolved, and what those changes mean for investors and financial advisors trying to build well-diversified portfolios. We also looked at correlation trends during periods of rising interest rates, elevated inflation, and economic recessions.
One key finding: higher inflation usually leads to closer links between stocks and bonds, reducing the benefit of including both in a portfolio.
The resurgence in inflation that started in May 2021 made market conditions much more challenging. Supply chain disruptions, a tight labour market, the war in Ukraine, and strong economic growth all conspired to push up inflation from its previously benign levels. The year-over-year change in consumer prices rose to more than 7% by the end of 2021 and reached as high as 9% by mid-2022. Inflationary pressures eased during 2023, but inflation remained above the Federal Reserve’s stated target of 2%.
Higher inflation marked a sharp reversal from the previous regime. For most of the previous 30 years, conditions were unusually benign from an inflation perspective. Aside from a brief increase in the mid-2000s, inflation had generally been running well below its long-term historical average of about 3.2%.
Cooler-than-average inflation, in turn, created close to ideal conditions for stock/bond correlations. With inflation mostly a nonissue, stocks and bonds moved largely independently; in fact, rolling three-year correlations between stocks and bonds were consistently negative (or barely above zero) from November 2000 through 2020.
A Sharp Increase in Correlation
With those conditions now a distant memory, it shouldn’t come as a surprise that correlations between stocks and bonds have sharply increased. Correlations between stocks and bonds edged into positive territory in 2021 and jumped up to 0.58 for the full year in both 2022 and 2023.
The recent uptrend in correlations has been unusually dramatic but not unprecedented. As I discussed in myprevious article, the stock/bond correlation has often been positive over multiyear periods. For example, the trailing three-year correlation coefficients between the two asset classes were consistently above zero from August 1966 through August 1974. Stock/bond correlations were also consistently positive from October 1974 until late 2000.
We also looked at correlations over specific periods of higher inflation, generally defined as periods when year-over-year inflation increased by at least 5% and remained high for at least six months.**
As shown in the table below, correlations between stocks and bonds rose during some but not all periods. In general, correlations increased the most during periods when inflation was both high (in the double digits) and protracted (lasting at least three years). The post-World War II era saw an unusually high spike in inflation (driven by the removal of wartime wage and price controls, combined with large numbers of troops coming home), but the increase in consumer prices lasted only about a year. More recently, surging economic growth in China fuelled rising consumer prices in 2007 and 2008, but inflation remained below 6% and lasted less than a year.
The most dramatic correlation upturns took place in the periods from February 1966 through January 1970 (driven by low unemployment and surging economic growth) and February 1977 through March 1980 (driven by soaring oil prices, the oil embargo and related price shocks, and expansionary monetary policies). Correlations ended up in a similar range (0.26 and 0.28, respectively) in both periods. Thanks to the rapidly shifting landscape for both interest rates and inflation, the recent upturn in stock/bond correlations has been even more pronounced.
Portfolio Implications - Should You Avoid Bonds?
There are a couple of key lessons to draw from these patterns. For one, the environment for both inflation and interest rates has fundamentally changed. As long as the outlook for inflation and interest rates remains uncertain, the correlation between stocks and bonds will probably remain higher than in the past. Indeed, correlations between stocks and intermediate-term government bonds stood at about 0.6 for the trailing 12-month period through April 30, 2024.
That doesn’t necessarily mean investors should avoid bonds, however. Stocks and bonds tend to move more in tandem during inflationary periods, but bonds can still provide significant diversification benefits, as well as play a critical role in providing ballast and reducing risk at the portfolio level.
* Correlation means that asset classes tend to move in the same direction
** Inflationary periods are based on the parameters described in Neville, H., Draaisma, T., Funnell, B., Harvey, C.R., & Van Hemert, O. 2021. “The Best Strategies for Inflationary Times.”ssrn.com/abstract=3813202.
FAQs
We also looked at correlation trends during periods of rising interest rates, elevated inflation, and economic recessions. One key finding: Higher inflation usually leads to closer links between stocks and bonds, reducing the benefit of including both in a portfolio.
What is the correlation between stocks and bonds? ›
Generally, when inflation is high and volatile, stocks and bonds have a positive correlation. That is, their prices move in the same direction (downward). When inflation is low and stable, stocks and bonds tend to have a negative correlation.
How does inflation affect the stock market? ›
As inflation in a country rises, the central banks increase the interest rates to gain control. Higher interest rates erode market liquidity, resulting in a bearish condition with reduced stock prices. In such a scenario, most investors sell off their stocks to avoid huge losses.
What is the historical correlation between stocks and bonds? ›
“We explored the implications of the correlations on multi-asset portfolio risks (see Figure 1 below) and found that the 60/40 stock/bond portfolio's volatility fluctuates significantly with these correlations—showing a decrease from about 10.5% to 8.4% as correlations shifted from positive (+0.35) in the period 1970– ...
What are the worst investments during inflation? ›
Some of the worst investments during high inflation are retail, technology, and durable goods because spending in these areas tends to drop.
How does inflation affect bond prices? ›
Ans: Inflation prompts central banks to raise interest rates, causing existing bond prices to decline. Conversely, during low inflation, rate cuts lead to increased bond prices.
Why are stocks and bonds inversely correlated? ›
Historically, when stock prices rise and more people are buying to capitalize on that growth, bond prices typically fall on lower demand. Conversely, when stock prices fall, investors want to turn to traditionally lower-risk, lower-return investments such as bonds, and their demand and price tend to increase.
Do stocks go up when inflation is high? ›
Analysts suggest that the short-term dynamic is less favourable, and that the relationship between equity prices and inflation is (quite frequently) an inverse correlation – ie as inflation rises, stock prices fall, or as inflation falls, stock prices rise.
How do inflation and interest rates affect stocks? ›
When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.
What is the return of the stock market after inflation? ›
Average annual return of the S&P 500
Over the long term, the average historical stock market return has been about 7% a year after inflation. Looking at long periods of time rather than any one year shows something else—remarkable consistency.
A correlation of 1.00 indicates perfect correlation, while lower numbers indicate that the asset classes are not correlated and generally do not move in tandem with each other—or, when the market moves down, these asset classes may not fall as much as the market in general, which could mitigate risk in your portfolio.
Are bond prices and stock prices positively or negatively correlated? ›
The negative correlation between equities and bonds plays a key role in the construction of diversified portfolios.
What is the correlation between inflation and stock returns? ›
Key Takeaways. Rising inflation can be costly for consumers, stocks and the economy. Value stocks perform better in high inflation periods and growth stocks perform better when inflation is low. Stocks tend to be more volatile when inflation is elevated.
Who gets rich during inflation? ›
Inflation can have varying effects on different wealth brackets with the middle class benefiting from real estate assets, but facing challenges in other areas. The "wealth effect" benefits those with substantial assets from increased asset values, like stocks, real estate and entrepreneurial endeavors.
Which stocks do best during high inflation? ›
Best Inflation Protection Stocks of June 2024
| Company (TICKER) | Yearly EPS Growth Estimate (5-Year Average) |
|---|
| Merck & Company, Inc. (MRK) | 93.0% |
| AstraZeneca PLC (AZN) | 13.6% |
| Cencora, Inc. (COR) | 9.3% |
| Church & Dwight Company, Inc. (CHD) | 9.3% |
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Lenders are hurt by unanticipated inflation because the money they get paid back has less purchasing power than the money they loaned out. Borrowers benefit from unanticipated inflation because the money they pay back is worth less than the money they borrowed.
What is the relationship between bond market and stock market? ›
Bonds affect the stock market because stock prices tend to rise as bonds fall, and vice versa. Bonds compete with stocks for the investor's dollar, as bonds are often considered safer than stocks. However, bonds usually have lower yields. When the economy is booming, shares tend to work out better.
What is a good balance between stocks and bonds? ›
Income, Balanced and Growth Asset Allocation Models
We can divide asset allocation models into three broad groups: Income Portfolio: 70% to 100% in bonds. Balanced Portfolio: 40% to 60% in stocks. Growth Portfolio: 70% to 100% in stocks.
What is the best ratio for stocks and bonds? ›
For example:
- You can consider investing heavily in stocks if you're younger than 50 and saving for retirement. ...
- As you reach your 50s, consider allocating 60% of your portfolio to stocks and 40% to bonds. ...
- Once you're retired, you may prefer a more conservative allocation of 50% in stocks and 50% in bonds.
The greatest difference between stocks and bonds are their risk levels and their return potential. Speaking very generally, stocks have historically offered higher returns than bonds but also come with increased risk. While you may earn more with stocks, you may also stand to lose more.
