Asset class correlations look set to remain higher for longer in the higher-for-longer rates environment, a new FTSE Russell study suggests, posing a potential threat to portfolio diversification strategies.
The FTSE Russell analysis found a marked “structural break” in asset class return correlations delineating the post-COVID era and the previous two decades when US bonds and equities moved largely in opposite directions.
Even the shock of the 2008 global financial crisis failed to disrupt the 21st century trend of negative correlations between the performance of US shares and fixed income assets as quantitative easing and persistent low inflation kept the fairy tale narrative flowing.
“… the post-Covid inflation shock, together with the current ‘higher-for-longer’ policy interest rates, may provide the best explanation for the rise in the correlation of asset returns since the end of the Goldilocks era, which was characterised by low and stable inflation and interest rates,” the FTSE Russell paper says.
“Indeed, this observation is consistent with the longer-term evidence showing that ‘higher stock-bond correlations tend to follow higher short rates and (to a lesser extent) higher inflation rates’.”
But the switch to positive correlations between asset classes has stuck through both the initial sharp rise in inflation over 2021 to 2022 and the ‘disinflationary’ period of last year, the study says.
While the asset class correlations have eased somewhat in 2024, the FTSE Russell report says a return to pre-COVID conditions may be possible but likely subject to much greater volatility compared to the first 20-odd years of this century.
Stock-bond diversification benefits – as showcased by the standard 60/40 portfolio – will probably be “more variable over time”.
“The persistence of higher correlations in the returns of multiple asset classes, and further evidence that the relationship of those correlations with inflation is both unstable and non-linear would pose a serious challenge for portfolio diversification,” the study says.
A sequel analysis by the panel of authors, including FTSE Russell head of global investment research, Indrani De, will explore whether the same coupling of asset class returns is evident in non-US markets.
FTSE Russell, one of the big three index providers, is a subsidiary of the London Stock Exchange group.