For the last 20y, reliably negative stock-bond correlation has allowed asset allocators to lean into equities and reach a bit further for returns as bonds helped keep a lid on portfolio risk. But thus far in 2022, US bonds have not been a hedge to US stocks, with the S&P 500 and Treasuries declining in tandem, disquieting to many investors unaccustomed to such positive correlation.

Supply disruptions, fiscal sustainability worries, and heightened monetary policy uncertainty – many of the factors that have historically been key determinants of US stock-bond correlation – may be coalescing into a perfect storm that could cause the recent spell of positive stock-bond correlation to become more long-lasting.  Indeed, signs of a regime shift may already be visible, and it may be time for CIOs and asset allocators to reconsider some of the long-held bedrock assumptions that have gone into portfolio construction.

For a CIO, the natural question to ask is, “If US stock-bond correlation were to turn positive, could there be other sovereign bonds that could take the place of US bonds as a hedge to US stocks?”  In a word, in our opinion, the answer is “No.”

Using data covering more than 50y and spanning six developed market (DM) countries, we find that DM local stock-bond correlations are determined by both local macroeconomic factors and common global macroeconomic factors (proxied for by the US) that relate to policy rate uncertainty, monetary policy independence and fiscal policy sustainability.

For investors, the importance of these common global drivers makes stock-bond correlation regimes highly synchronized across DM countries.  As such, it is critical for CIOs to think both globally and locally when monitoring macroeconomic conditions to assess the likelihood of a stock-bond correlation regime shift.  If US economic and policy forces were to increase the likelihood of a switch in the US stock-bond correlation regime, the risk of a similar switch in stock-bond correlation regime in other DMs would rise too.

Unfortunately, the high degree of stock-bond correlation synchronicity across the DM countries means that when US stock-bond correlation is positive, diminishing the hedging properties of US bonds, no other DM bond (hedged USD) provides a better alternative, making it difficult to find low-risk, sovereign bonds with equity hedging properties.  Additionally, although data are scarce, there is little evidence to suggest that EM sovereign bond returns (USD hedged) would be reliably negatively correlated with US stock returns when US bonds are not. 

A positive stock-bond correlation regime could persist for decades – as it did in the US from the mid-60s until the turn of the century – and would likely be widespread across DMs.  But it would hardly be a “black swan” event as there is ample history to lean on to envision what a world would look like without negatively correlated stocks and bonds. 

A change in correlation regime is not a forgone conclusion.  A bout of “risk-off/risk-on” sentiment, with investors re-rating stock and bond risks relative to each other, first bidding up safer bonds at the expense of riskier stocks and then quickly reversing course, would induce negative stock-bond correlation and obscure, for a time, the slower-moving impact of fiscal and monetary policy shifts that support positive correlation.  The risk-off reaction to the Russian invasion of Ukraine in Q1 2022 is a case in point. 

However, risk-driven dynamics tend to be short-lived and, ultimately, policy factors that are supportive of regime change may regain traction and influence.  As such, the prudent path forward may be to keep a watchful eye on both local and US policy conditions and to prepare for an extended period of positive stock-bond correlation.