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How inflation disrupts the bond-equity correlation

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4 Aug 2022

The inverse correlation between equities and bonds has been debunked in 2022 and inflation could be a reason, as Mona Dohle reports.

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The inverse correlation between equities and bonds has been debunked in 2022 and inflation could be a reason, as Mona Dohle reports.

Economics is often approached like a science, which has hard and solid laws. Science tells us that water expands when frozen and that the correlation between altitude and temperature is negative.

In economics, one of these presumed laws, the cornerstone of modern portfolio theory, is that equities and bonds are negatively correlated. When stock markets slide, bonds tend to perform better.

This is why most institutional portfolios feature a combination of fixed income and shares. But the iron laws in economics are far less static. It could be argued that it is a social, rather than natural science.

What happens when this presumed iron law no longer holds true? Throughout the last year, the inverse correlation between bonds and stocks has increasingly broken down. Year to date, the S&P500 has fallen by more than 20% while yields on 10 year US treasuries have been pushed to 2.5%. In the UK, the FTSE100 has dropped by 4.5% while the yield for 10-year gilts stands at almost 2.4%. For investors who rely on both asset classes as their main source of portfolio diversification, this is a potential double whammy. But how persistent is this trend?

Inflation appears to be a driving force. Rising price levels are making bonds less attractive while the prospect of monetary tightening has sent jitters through overvalued equity markets.

While this correlation is fairly unusual for the past 20 years (see chart), investors who have been around for longer recall that things used to be different.

5 year rolling bond equity correlation

Indeed, back in 2016, research by Matt Roberts-Sklar for the Bank of England revealed that for the past 250 years, equities and bonds were positively correlated. He stressed that it was only when investors became less concerned about inflation in the early 2000s that the correlation turned negative.

This implies that bonds could become attractive again, provided central banks, the Fed in particular, bring inflation under control, predicted Andy Sparks and Juan Sampieri in an article for MSCI published in June.

Investors have so far hold off from significantly reducing their fixed income exposure in response to inflationary threats. After all, defined benefit (DB) schemes have no choice but to remain invested in fixed income.

But growing demand for alternatives and private markets among defined contribution and open DB schemes suggests that investors are increasingly careful not to place all their eggs in two baskets

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