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Written by: Gabriela Santos
For three years, stock and bond returns have been moving in the same direction. When times are good, this is not thought of as a problem; however, when stocks sell off and bonds are not there to catch them, then investors are faced with an important portfolio construction challenge to solve. This year, equities have continued to be sensitive to daily moves in Treasury yields as the macroeconomic narrative continues to change frequently. April was a great example: the S&P 500 had a 5.5% correction, while 10-year Treasury yields move up 50bps resulting in a -2.5% return for the Bloomberg U.S. Aggregate. If bonds can’t be counted on to zag when equities zig, then how can investors diversify the risk side of their portfolios? Going forward, investors need to count on a team of diversifiers rather than just one star player – and private markets can offer alternative solutions to the diversification game.
For 20 years, stocks and bonds were negatively correlated (on average -0.4). When stocks fell, quality bonds provided an offset, as yields moved down and bond prices moved up. An important change has occurred since then: inflation. Post-GFC and pre-pandemic, inflation consistently surprised to the downside and the Federal Reserve focused on the employment rather than inflation side of its mandate. The “Fed put” was always there when stocks wobbled. This changed in 2020: inflation surprised sharply to the upside and the Fed became lazer focused on fighting inflation. As 2024 began, there was reason to hope that inflation and rate hike worries were left in the past, but three months of hotter than expected inflation prints threw cold water on dovish Fed expectations.
We do expect inflation to resume its slow downward march; however, we also believe that inflation uncertainty is a feature not a bug of this new cycle. Several anchors that pulled inflation down over the past decade are not as strong over the next decade: globalization, energy prices, and inflation expectations. In addition, concerns over the large fiscal deficit and the premium needed to absorb large Treasury issuance has become top of mind for investors, affecting the long end of the yield curve. As a result, investors can still count on core bonds for diversification when worries center around recession, but other solutions are needed for inflation and deficit concerns. Private markets are a key place to look for alternative solutions.
As shown on page 8 of the 2Q Guide to Alternatives, certain pockets of Alternatives can offer low to negative correlation to public markets. These include real assets (real estate, infrastructure, and transportation) as well as hedge funds. Real assets tend to act as a natural inflation hedge as higher costs can be passed on through higher rents and utility bills. In addition to inflation protection, real assets are benefiting from key tailwinds: growing renter base for multi-family housing, e-commerce and AI-driven demand for industrial real estate, the energy transition and infrastructure spending supporting infrastructure assets, and shifting supply chains pushing up transportation leases. Lastly, hedge funds can better offer diversification and returns from now on given higher interest rates and more elevated volatility across asset classes. Of course, risks do exist, especially in older office commercial real estate, more cyclical infrastructure assets, and of course in underperforming managers.
Episodes of positive stock/bond correlation a feature not a bug this cycle
S&P 500 and 10-year Treasuries, rolling 12-month correlation based on total returns
Source: Bloomberg, Datastream, FactSet, LSEG, Standard & Poor’s, J.P. Morgan Asset Management. Guide to Alternatives. As of May 31, 2024.
Related: Is U.S. Dominance in Global Equity Indices Overdone?