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Written by: Maria Nikitanova and Dane Smith | SSGA
Inflation soared in the post-COVID period, and markets became laser focused on inflation data and its potential impact on central bank policy. Higher interest rates coinciding with a lower equity risk premium, causing stock/bond correlation to turn from negative to positive. This trend has made it harder for investors to use fixed income as a hedge against equity beta risk.
In this paper, we dig deeper into the reasons behind positive correlation across various regional markets, including the US.
Market Concerns and Movements in Stock-Bond Correlation
In examining stock-bond correlation, we consider markets either growth- or inflation-oriented depending on external macroeconomic factors and internal sentiment. During periods of economic expansion, investors are more concerned about the potential for the economy to overheat and produce inflation, whereas in crisis periods, they are more worried about future economic growth. This growth-inflation trade-off could also indicate how investors view their allocations to the US bond market. Allocation decisions may depend on whether investors are centrally focused on hedging (elevated inflationary periods) or growth (weaker economic periods). In turn, the growth-inflation trade-off can help explain movements in stock-bond correlation.
Periods of Inflation Concerns
Intuitively, in high-inflation environments, investors — who want to preserve their capital — are more concerned about price levels than growth in equity markets. Consequently, they might want to own some assets that are more inflation-safe, which could limit demands for long-duration fixed income. They may also expect the government to combat inflation with tighter monetary policy, which could also limit demand for bonds.
Meanwhile, periods of higher inflation have been associated with decreasing stock prices. Thus, in these circumstances, stocks may be falling at the same time as bond values, and the correlation is positive. Evidence of inflation impact on stock-bond correlation in the US can be tracked in the past few years. GDP growth of 2.4%, in line with a 5.1% increase in the consumer price index since 2020, which is well above its target, clearly shows that the correlation jumped after inflation went over its target (Figure 1).
Periods of Growth Concerns
During low-inflation periods, growth concerns are typically prevalent. Lower economic growth could result in investors questioning earnings growth and equities performance. However, these same periods favor bonds as a safe asset — while not competitive with equities from the standpoint of the return, bonds offset potential losses from equities. Thus, we may see a negative correlation in markets centrally focused on growth.
This negative correlation prevailed in the markets in the first two decades of the 21st century, until 2020 — as the inflation rate was stubbornly low and stable around 2%, growth concerns were on market participants’ minds more than inflation concerns. During this period, the stock-bond correlation remained negative. A market concerned about growth could also view low GDP growth and low inflation indicating the potential for a recession. From 2000 to 2020, US real GDP growth averaged 2.1% with inflation of 2.1%, raising investors’ concerns around future economic growth that resulted in a negative correlation.
A Global Look at Stock-Bond Correlation Data
US
Data show that in the US, higher inflation almost always corresponds to positive stock-bond correlation. For example, from December 1978 to December 1999, high inflation due partly to oil price shocks corresponded with positive correlation. Figure 1 shows the period from January 2000 onward, when inflation was mostly tepid, coinciding with negative stock-bond correlation. However, inflation exerted its dominance following global price increases related to COVID lockdowns and fiscal stimulus, as evidenced by the consumer price index soaring well above the US Federal Reserve targets. Markets were laser-focused on inflation, which turned correlation positive.
Globally
In the current environment, the same relationship can be seen in regions other than the US. Japan and the EU also highlight this trend, with periods of high inflation coinciding with rising stock-bond correlation.
After 2020 — as in the US, mainly due to economies reacting to the post-COVID environment through government support and increased stimulus-related consumer spending — inflation increased, as did stock-bond correlation (Figures 2 and 3).
In Japan, the correlation between bonds and equities has been consistently negative until recent years, as a long-term low-inflation environment (and sometimes deflation) finally pivoted to increasing inflation. Japan’s struggle to escape its undesirably low inflation was unexpectedly resolved by COVID-19 consequences such as higher import costs and supply chain disruptions — when stock-bond correlation also began rising. As a previously cash-heavy economy has adjusted to new circumstances, stock-bond correlation has become predictable by looking at inflation movement.
In EU countries, stock-bond correlation and inflation are historically less codependent. However, in the past few years, stock-bond correlation has followed the path of inflation, rising to record-high levels.
The Bottom Line
In conclusion, data shows that inflation and growth may have asymmetric effects on stock/bond correlation; inflation shocks have tended to correspond with positive correlation, while growth news tends to correspond with negative correlation.
Today, as we are late in the business cycle, growth could further compress, leading to a flight to quality and a market less worried about inflation. A typical risk-off response could ensue, bringing negative correlation back to the investment landscape. However, it is important for investors to consider ways to manage global variations in correlation as markets head down an uncertain path in the coming year. For more information, see Portfolio Construction Beyond 60/40: Improving Durability and Diversification in Portfolios.
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