Our friends at Mt. Lucas shared what we think to be a really important analysis of how equities and bonds correlate to each other during inflationary environments.
The question is whether it is safe to assume that stocks and bonds always have negative correlation or if the past few decades of such low correlation may be a result of something else. The argument from Mt. Lucas is that the negative correlation over the past few decades has been in part attributable to the low inflationary regime over the period.
Periods of higher inflation have historically resulted in positive correlation between stocks and bonds. During periods of higher inflation, you tend to see rising interest rates, knocking bond prices down and putting pressure on equity multiples. It is much harder for monetary policy to operate in higher inflation environments to combat slowdowns.
From the post:
When inflation came back with a vengeance driven by pandemic supply chains getting overwhelmed with fiscal and monetary stimulus, then exacerbated by geopolitics and war, stocks and bonds fell together, partly as the starting point for yields was so low and durations so high. It depends exactly where you draw your lines, but long duration bonds – a diversifying asset relied upon to cushion equity markets – hit a drawdown approaching 50%. Traditional portfolios, built on that bedrock regime, only had one side of the distribution in one asset class to help diversify stocks – positive bond returns.
Portfolio construction relies on uncorrelated assets – preferably negatively correlated in times of stress. We have updated the chart in the aforementioned blog to include data points since 2022, noted in red. Possibly a return to the 1973 to 1998 regime- higher inflation environment, and positive stock bond correlation.
And here is what we believe to be the "money" part of this analysis. Based on what Mt. Lucas is seeing, from 2022 we are moving into both a higher inflation environment AND positive stock/bond correlation: