The relationship between equities and bonds tends to depend on whether market sentiment is driven by economic growth or inflation. When investors are primarily concerned about economic growth and less worried about inflation, as was the case from 2000-2020, bonds and equities tend to be negatively correlated. Better growth prospects are typically good for equities but not for bonds, with the opposite being true when growth falters.
However, when investors are more concerned about inflation than growth, correlations tend to be positive, as was the case between 1980 and 2000 and since 2022. In this scenario, central banks’ efforts to control inflation through interest rate hikes or cuts become the dominating market force. A more hawkish central bank puts pressure on both bonds and equities, while the reverse is true of a dovish central bank.
Rolling 3-year correlation of monthly returns of S&P 500 and Bloomberg US Treasury Total Return indices. Source: Bloomberg, Fidelity International, June 2024.
What caused positive correlations in 2022?
2022 was a notable year for many multi asset investors because it was the first time for several decades that both bonds and equities fell in value in a calendar year, a result of the bond-equity correlation swinging sharply positive after several decades of being negative.
Annual return of MSCI World Net GBP Total Return Index and Bloomberg Global-Aggregate Total Return Index Value Hedged GBP. Source: Fidelity International, Bloomberg, 2024.
Historically, correlations between equities and bonds have often been positive during supply-side economic shocks or when inflation exceeds central bank targets, prompting policymakers to adopt a more restrictive monetary policy.
During 2022, global economies were in the midst of a supply-side shock amid extended Covid-19 lockdowns in China, with further shocks then coming from Russia’s invasion of Ukraine. Inflation soared, prompting aggressive interest rate hikes by global central banks. This caused both equity and bond prices to fall, as investors anticipated tougher operating conditions for firms and the interest rate outlook changed significantly.
Correlations are important, but not as important as diversification
Why are correlations important? In general, the benefits of diversification are increased when equities and bonds are negatively correlated. The picture that often springs to mind is one of bond prices rising in times of market stress to offset any falls in the value of the equity portion of a portfolio. But when correlations are positive, the diversification benefits of holding both bonds and equities tends to be lower and years like 2022 become possible.
However, conditions like those seen in 2022 are rare. Even in periods of higher or positive correlations, the benefits of diversification are still present. As long-term investors, we understand that conditions inevitably change. Our aim is to design portfolios built on sound investment principles that are resilient to fluctuations in the macroeconomic and market environment.
One of the key aspects of the Fidelity Multi Asset Allocator range is that it aims to look through short-term market volatility, and focuses on the longer-term relationships across different assets classes. In the short-term, equities and bonds have been more positively correlated and we expect to see periods of higher correlation in the medium term too.
As the analysis in Chart 3 below shows, even in the period of higher correlations from 1980-2000, a basic mix of equities and bonds reduced the volatility of a portfolio with only a small compromise to returns compared to a portfolio with only equities. In addition, a 60/40 portfolio would have reduced the maximum drawdown compared to a portfolio of only equities (Chart 4).
