Why stocks and bonds are moving in the same direction – down
- An increasingly stagflationary environment has reversed the traditional relationship between the two asset classes, with both bond and stock markets struggling amid high inflation, slowing growth, rising interest rates and a hawkish Federal Reserve
While historically stock and bond performances have tended to move in opposite directions, both asset classes have seen negative returns in the year to date with an increasingly positive correlation.
Higher interest rates mean increased borrowing costs which cools economic activity by weighing on business capital expenditure and consumer spending, and may further slow down growth. Investors are worried that interest rates may be increased too much too quickly, which could tip the economy into a recession.
Having said that, we believe that inflation in the United States can moderate without a recession as the Fed will do its utmost to engineer a soft landing for the country’s economy. Economic growth will inevitably slow this year but inflation should moderate as reopening demand subsides and supply chain pressure alleviates over the course of the year.
This would allow the Fed to moderate its hawkish tone, thereby supporting both the US equity and fixed income markets. In the near term, however, market volatility may continue before there’s more clarity on the Fed’s tightening plans.
To soften the impact of equity market volatility, investors traditionally relied on the negative relationship between stock and bond performances to diversify their risks. The average correlation between the weekly returns of S&P500 and Bloomberg US Aggregate Bond Index has been -37 per cent over the past two decades, meaning as equities underperformed, fixed income typically outperformed, and vice versa.
We expect such a trend to continue in the near term as both asset classes continue to digest high inflation and hawkish monetary policy, which tends to drive stocks and bonds in the same direction. As the rise in real interest rates stabilises and inflation moderates, the stock-bond relationship may gradually return to negative.
Marcella Chow is a global market strategist at J.P. Morgan Asset Management