Is the Stock-Bond Diversification “Free Lunch” Back on the Table?

Additional content provided by John Lohse, CFA, Sr Analyst, Research.

Nobel Laurette economist Harry Markowitz famously asserted that diversification is the only free lunch in investing; however, for much of the last four years the availability of this free lunch has been somewhat diminished. During this time, stocks and bonds have been showing positive correlation, moving in the same direction as each other, reducing diversification benefits for multi-asset portfolios. However, the 21-day stock-bond correlation between the S&P 500 and the Bloomberg U.S. Treasury Index turned negative and finished August at its lowest point in 15 months —closing out the month at -0.34. So, what happened and what could this mean for a multi-asset portfolio investor?

Fed Rate Policy Influencing Stock-Bond Correlations

The labor market is cooling at a measured pace, with August’s change in non-farm payrolls coming in below estimates and July’s revised print was the lowest reading since December 2020. Businesses have signaled an increased hesitancy to hire at the same pace as last year. This, combined with slowing inflation, gives the Federal Reserve (Fed) a clear runway to begin cutting interest rates. Bond futures markets are currently pricing in a 100% probability of at least a 25-basis point (bps) cut following the Federal Open Market Committee (FOMC) meeting on September 18, with traders also leaving the door open to a more substantial 50 bps cut.

The almost certain change in policy whipsawed bond prices in August, causing the ICE BofA MOVE Index (a measure of bond volatility) to spike above 120, a level not registered since January of this year. This came while equity volatility, as measured by the CBOE Volatility Index (VIX), rose sharply, increasing to its highest point since October 2020. Both stocks and bonds posted positive gains in August, with bonds firmly placing themselves in positive territory for the year. Although both asset classes finished higher, there was latent churning that led to a dispersion in correlations. The chart below highlights the 21-day stock and bond correlation turning negative in August, exhibiting a different pattern than much of the prior year.

21-Day Correlation Between the S&P 500 Index and the Bloomberg U.S. Treasury Index

Source: LPL Research, Bloomberg 09/09/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Below highlights the timing of the stock and bond volatility spike in Early August, commensurate with the short-term correlation reading turning negative above.

Stock and Bond Volatility Spikes in August

Bonds (LHS), Stocks (RHS)

Source: LPL Research, Bloomberg 09/10/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Inflation and Growth Explain Much of the Stock-Bond Correlation

The interplay between inflation and economic growth plays a key role in shaping stock-bond correlations, especially when looking at longer periods. Historically, equity and bond markets have demonstrated opposite sign reactions to growth news but the same sign reactions to inflation news. As such, much of the stock bond correlation depends on the relative strength and importance of growth and inflation to the markets.

Historically, throughout the 2000s and 2010s, stock and bond correlations were mostly negative, as inflation concerns were relatively contained, while the past four years have seen a positive relationship, as the effects of COVID-19 rippled through the economies (not just in the U.S. but globally) raising inflation uncertainty. From August 30, 2020, to August 30, 2024, the monthly correlation between the S&P 500 and the Bloomberg U.S. Treasury Index was 0.57. From August 30, 2000, to August 30, 2020, the monthly correlation was -0.38. The chart below highlights this 21-day reading on a longer-term basis, since August 30, 2000.

Historical Lookback of 21-Day Correlation Since August 2000

Source: LPL Research, Bloomberg 09/10/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

During periods of high inflation uncertainty, policy makers are more focused on combating price increases with proactive monetary policy, where central banks aim to direct the real economy. High inflation, often driven by supply side shocks like geopolitical events or natural disasters, generally leads to higher interest rates and tighter financial conditions. During such periods, stocks and bonds have both suffered as inflation pressures increased, and gained as they shrunk, hence exhibiting positive correlation. During periods of low and steady inflation, economic growth will take a higher precedent among market participants and policy makers. Monetary policy tends to be more reactive with central banks reacting to what is happening in the real economy. This leads to an environment with a positive growth-inflation correlation where good news for economic growth increases the likelihood of rate hikes (and vice versa). This in turn yields an environment with a negative stock-bond correlation where good news for the economy is good news for equity prices (as the potential for future earnings grows) but bad news for bonds as rate hikes may follow. The reverse is true, for bad news that is likely to be bad for stocks’ earning potential (and hence prices) but good for bonds (given increased likelihood of rate cuts).

The steady declaration of inflation over the past year has allowed the Fed to shift its focus to the labor market and economic growth as a proxy. Looser interest rate policy as a response to softening economic growth depressing equity prices is signaling a return to negative correlations between stocks and bonds. Equity market returns are often directed from a myriad of influences including company earnings (we’ve recently seen signs of a broadening of earnings growth), geopolitical events (wars in the Middle East and Ukraine have not abated), and technical backdrops (momentum indicators have turned bearish, and signs of defensive leadership have begun to emerge); however, as inflation worries largely disappear into the rearview mirror we may be witnessing a return of bad news (for growth) being bad news for stocks and good news for bonds (negative stock-bond correlation).

Implications for Portfolio Construction

The negative stock-bond correlation exhibited by markets through much of the 21^st century proved to be a very effective tool in portfolio construction as investors could deploy stock and bond mixes capable of complimenting each other during market cycles. Over this period, this inverse relationship helped many multi-asset portfolios weather stock market and/or economic downturns with bond allocations often providing a ballast when stocks were down. With a positive stock-bond correlation, as we have seen for much of the past four years, some of this diversification effect is lost (although any correlation under 1 still provides some diversification effect). As a result, the efficient frontier shifts and investors must take on more risk, though not much more, to achieve the same expected return.

The inverse relationship between stocks and bonds has been restored over a short-term time frame but we’ll want to witness continued trends of stocks and bonds not moving in tandem before we can call for a return to “normal”. We believe that bonds should continue to play an important role in portfolio construction, given the diversification effect they demonstrate even with a positive stock-bond correlation (less than 1). Bonds generally experience smaller drawdowns than stocks, (2022 was the first year since 1977 that both stocks and bonds experienced a down year) and provide income to portfolios, with the vast majority of bond returns having come from income generation itself. Portfolios can also maintain diversification, even in periods of increased stock-bond correlation, by increasing allocations to alternative diversifiers like commodities or liquid alternatives.

Conclusion

While it’s still early in this trend, LPL Research welcomes a shift to a regime of negative stock-bond correlation as it allows multi-asset investors to take more advantage of the “free lunch” of diversification. We continue to consider core fixed income as an attractive asset class, and an integral part of most multi-asset portfolios. Within core fixed income, we maintain a preference for up-in-quality credit exposure and a neutral interest rate sensitivity (duration) relative to benchmark indexes, while monitoring signs of a potential stock market correction. We continue to hold a strong overweight to preferred securities as valuations remain attractive. LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) anticipates heightened levels of volatility as multiple signals come to bear on the economy, elections, and the seasonality backdrop.