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Throughout the last decade, the negative correlation between bonds and equities was often cited as a key benefit for holding bonds within a portfolio. This was especially poignant throughout the 2010s when bond yields were negligible to negative in Europe.
Of course, the bond backdrop today is significantly improved, with even the safest government bonds offering positive low single digit annual yields. Hence bonds not only offer potential diversification but also significantly positive expected returns. This is beneficial as it reduces the return requirement from the equity allocation in a multi asset portfolio. It is no longer the case that the returns profile is heavily reliant on equity performance.
Focusing on correlation again, as seen in markets after the onset of Covid, the negative correlation which markets became accustomed to is far from guaranteed. The chart below highlights that when the US economy moved to a high inflationary period (inflation above ~3.5%), the correlation between stocks and bonds has generally been positive. In contrast to this, during a low inflationary period the correlation has turned negative. So, while bond market performance will typically have an inverse relationship with inflation trends, the relationship for equities is more nuanced: whether or not inflation is beneficial for equities is highly reliant on the level of inflation and the subsequent impact of central bank activity on financing conditions.
The good news here however is that the rate of inflation continues to trend in a downward direction which, based on history, suggests a lower correlation between stocks and bonds. If so, the combination of positive bond yields and greater diversification benefits argue strongly in favour of a constructive outlook for multi-asset portfolio performance.
