Schroders Investment: If the negative correlation between US equities and bonds re-emerges, bonds will become a risk-off investment

On September 11, Schroders' asset diversification strategist, Li Junfeng, wrote that the correlation between stocks and bonds was the key pillar of the traditional 60/40 portfolio, which turned positive in mid-2022 due to various factors during the pandemic that led to high inflation. After the global central banks started taking large-scale monetary policy actions to lower inflation, Schroders began to see inflation gradually easing, and the Federal Reserve confirmed its dovish stance at the Jackson Hole global central bank conference. Inflation has yet to reach the target level, but has fallen significantly from its peak.

Li noted that in early August 2024, the market was sold off due to the unwinding of yen carry trades after the Bank of Japan raised interest rates and the weak US jobs market data, hitting the stock market, with the S&P 500 falling 6% from July 31 to August 5. However, bond yields fell during this period, while the US Treasury index rose 2.2%, which helped to mitigate the drawdown of the 60/40 portfolio.

As mentioned earlier, inflation is one of the main factors of the correlation between stocks and bonds, and is slowly and steadily cooling. The overall consumer price index (CPI) in July 2024 unexpectedly fell 0.1% year-on-year, while the core consumer price index rose 3.2% year-on-year as expected. This situation is conducive to curbing inflation. According to historical data, the long-term correlation is often negative when the core consumer price index is less than 2.5% year-on-year. If we find that inflation further declines, the long-term correlation may return to a negative state.

Li believes that if the negative correlation between stocks and bonds re-emerges as it was in the 20 years before the pandemic, bonds will be able to serve as a risk hedge again. A stable global economic outlook and the recovery of economic growth and inflation may help bonds to play their role.

However, even if inflation is no longer a major issue, the correlation between stocks and bonds may remain positive in various scenarios.

For example, investors may be disappointed with the speed of the normalization of economic growth, or may become increasingly concerned about fiscal deficits. In such cases, investors will need to reassess the role of bonds in their portfolios. A positive correlation may weaken traditional diversification strategies, so investors need to reassess asset allocation to achieve ideal risk-adjusted returns. Flexible asset allocation and research on other hedging tools may also be key factors in navigating this environment.