The basis of traditional portfolio construction and diversification is to build a portfolio with different asset classes that have a negative correlation to each other, and which will move in opposite directions as markets move. Historically, equities and bonds have been the core of many multi-asset portfolios and have provided this negative correlation, meaning investors have been able to construct well diversified portfolios, as well as hedging out some of the equity risk and portfolio volatility where appropriate.
However, in some growth sectors where we have seen stocks that have benefitted from the decline in bond yields this correlation is starting to reverse itself and turn positive, meaning that when equity prices rise, bond prices are also going up. Over the last five years, stocks in these sectors had been negatively correlated to bonds, but in the wake of the economic fallout and recovery from the Covid-19 pandemic, the current correlation has now turned positive. Other sectors which have a more value bias, while still negatively correlated to bonds, are now less so than they were before.
Historically, stocks and bonds have tended to go in the same direction during periods of heightened inflation concerns, so it remains to be seen whether the current trend of high inflation and positive correlations will evolve into something more long-term or whether there will be a reversion to previous correlations. A continuation in stocks and bonds moving together would mean a deteriorating ability to diversify a portfolio and the loss of any hedging benefits.
While traditional equity and bond asset allocations will continue to drive portfolio positioning, as many equity sectors do still have a negative correlation to bonds, investors might need to find alternative ways to diversify their portfolio if such positive correlations continue.