Will 2024 Mark the Return of a Negative Stock-Bond Correlation?
As nearly every investor knows, 2022 was a challenging year for equities. Inflation’s upside surprise caused the Federal Reserve to shift quickly from quantitative easing (QE) to quantitative tightening (QT), while aggressively raising the benchmark Fed funds rate from 0.1% to 4.4%.1 Stocks were pressured into a bear market, with the S&P 500 shedding -18.1% for the year.2
Normally investors would hope to mitigate some of the downside with a fixed income allocation. But that didn’t happen in 2022.
Instead, bond yields shot higher, as worse-than-expected inflation and the end of quantitative easing put upward pressure on the 10-year U.S. Treasury bond yield. The result was a big down year for the 10-year (-17.83%), with yields more than doubling from 1.6% to 3.88%. For the first time since 1958-1959, U.S. Treasury bonds (10-year) delivered two consecutive years of negative returns.
Rarely do we see across-the-board selloffs in fixed income coincide with a major stock market drawdown. This event gave investors a stark reminder: bonds are generally great hedges against growth shocks (recession-led bear markets), but they do not offer much cover during inflation shocks.
History reminds us as much.
If we look back at the late 1960s and 1970s, we can find another environment when stocks and bonds started moving in the same direction and an environment where inflation shocked to the upside. The 1973 oil embargo catalyzed already creeping inflation, and inflation expectations also started to drift higher. Positive correlation between stocks and bonds took hold.
It wasn’t until the late 1990s when a negative stock-bond correlation resurfaced, which was also the time when inflation expectations fell back down to more normal/neutral levels (slightly less than 3%). That negative correlation lasted for a little over 20 years, which meant that diversified stock-bond portfolios were largely effective at mitigating volatility and hedging against weak growth.
The two charts below illustrate how the relationship between inflation expectations and stock/bond correlation played out. In the first chart, readers can see that inflation expectations were elevated throughout the 1980s but gradually improved as consumers became more firmly convinced that inflation was in a sustained downtrend.
One- and Five-Year Expected Inflation
As inflation expectations become more anchored, the stock/bond correlation turned negative and stayed that way for over 20 years (chart below). We saw a positive correlation return when inflation and inflation expectations shot higher (2021 – 2022 in the chart above).
The good news today—and the reason I think a negative stock/bond correlation could return in 2024—is that inflation expectations have moved sharply lower from peaks, and could continue in a downtrend or at least hover below 3% for the year. But if inflation continues to moderate, history suggests that the stock-bond correlation could flip back to negative, much like we saw in the late 1990s.
Bottom Line for Investors
The return of negative stock-bond correlation would strengthen a ‘balanced’ portfolio’s ability to mitigate equity market volatility and also suggests that bonds would hold their own in a period of weak economic growth. I expect that 2024 will not feature weak growth, but a longer-term perspective looks favorable for a multi-asset, diversified portfolio—assuming such an allocation is appropriate relative to an investor’s goals and needs.
Disclosure
2 NYU. January 2024. https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
3 Fred Economic Data. March 12, 2024. https://fred.stlouisfed.org/series/EXPINF1YR#
4 Russell Investments. 2024. https://russellinvestments.com/us/blog/is-the-stock-bond-correlation-positive-or-negative
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