Equities/Bonds Historically Move in Tandem When Inflation Readings are Above 2.5%
Q3 saw US equities make new 2023 highs in July before retreating a bit in August, and a bit more in September, to close out the quarter down nearly -7% from that high.
This was far from a market panic, however, with the volatility rising only 4.5 points for the VIX, from the 13s to around 17.5. With every 4 points in the VIX roughly representing an increase of 0.25% in daily volatility, the Q3 down-move did not have market participants pricing that much more volatility, despite the sell-off.
Elsewhere, 60/40 portfolios continued to struggle as bond markets continued to see positive correlation to equities. That gets painted by many as an outlier, but history actually shows is the norm when inflation readings are above 2.5%.
The future remains cloudy, to say the least. On the interest rate side, comments from Chair Powell around an ultimate policy rate still being “some ways” from neutral gave markets pause. At the same time, signs of stubbornly high inflation persisted, with oil prices rebounding into the low $90s from the high $60s in July and rolling strikes among auto workers seeking substantial wage increases to cushion high living costs.
This uncertainty in interest rate policy will likely continue to drive higher volatility and correlation between stocks and bonds. That could spell continued trouble for a portfolio diversified with bonds alone and makes non-correlated diversifiers all the more attractive.