Portfolio Construction
A Changing Stock-Bond Correlation
Drivers and Implications
Q1 2023
Topics - Portfolio Construction Portfolio Risk and Performance Asset Allocation Equities Fixed Income Alternative Investing
An earlier version of this article was published as the Q2 2022 Alternative
Thinking
The relationship between stock and bond returns is a fundamental determinant of
risk in traditional portfolios. For the first two decades of the 21st century, the
stock–bond correlation was consistently negative and investors were largely
able to rely on their bond investments for protection when equities sold off. But
this was not the case in the previous century, and macroeconomic changes—such
as higher inflation uncertainty—could lead to a reappearance of the positive
stock–bond correlation of the 1970s, 80s, and 90s. This would have broad
implications for investors, either increasing portfolio risk or forcing allocation
changes likely to reduce expected returns. This article analyzes the implications
for investors of a change in this “golden parameter” and presents a
simple macroeconomic model to help understand its drivers, supported by
international empirical evidence. Finally, it explores the role of alternatives in
making up the potential diversification deficit in a positive stock–bond
correlation world.
Key Findings
• Historically, equity and bond markets have exhibited
opposite-sign sensitivities to growth news and same-sign sensitivities to inflation
news. According to a simple model, the stock–bond correlation thus depends not
on the level of inflation, but on the relative volatility of growth and inflation
and the correlation between them.
• Empirically, this model explains around 70% of long-term
variation in the US stock–bond correlation, with similar results
internationally. It is less successful at explaining short-term fluctuations.
• If a sustained rise in inflation uncertainty drives the
correlation higher in the present decade, investors can make up the diversification
deficit by raising allocations to alternative diversifiers, such as dynamic liquid
alternatives and commodities.
This document is not intended to, and does not relate specifically to any investment strategy or product that Lodestone Wealth offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
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has been obtained or derived from sources believed by the author and Lodestone Wealth Management
LLC (“Lodestone Wealth”) to be reliable but it is not necessarily all-inclusive and is not
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as secondary information and should not be the primary source for any investment or allocation
decision. Past performance is not a guarantee of future performance. Diversification does
not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not
represent valuation judgments with respect to any financial instrument, issuer, security or
sector that may be described or referenced herein and does not represent a formal or official
view of Lodestone Wealth. The views expressed reflect the current views as of the date hereof
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expressed herein.
The information contained herein is only as current as of the date indicated, and may be
superseded by subsequent market events or for other reasons. Charts and graphs provided herein
are for illustrative purposes only. The information in this presentation has been developed
internally and/or obtained from sources believed to be reliable; however, neither Lodestone
Wealth nor the author guarantees the accuracy, adequacy or completeness of such information.
Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be
relied on in making an investment or other decision. There can be no assurance that an
investment strategy will be successful. Historic market trends are not reliable indicators of
actual future market behavior or future performance of any particular investment which may
differ materially, and should not be relied upon as such. Diversification does not
eliminate the risk of experiencing investment losses.
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regarding future events, targets, forecasts or expectations regarding the strategies described
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