📈  Chart of the Week 3/30/2025

By Michael Allison, CFA

Correlation Regimes: Lessons from a Shifting Landscape

Back in January, we discussed the correlation of stocks and bonds over time. We looked at how incorporating a hedged equity allocation into a portfolio could make it more robust and better diversified than a traditional 60/40 stock and bond portfolio. That allocation could be sourced by lowering the allocation to bonds, and to a lesser extent, stocks.

In light of recent market volatility, this week I’d like to revisit that discussion, only this time through the lens of correlation regimes, i.e. extended periods of positive, negative or neutral stock and bond correlation.

In the real world application of modern portfolio theory, the correlation between stocks and bonds has long been treated as a bedrock principle of diversification. Investors have often enjoyed a negative correlation regime—particularly from the early 2000s through 2021—where equities and fixed income allocations danced in opposite directions. When risk assets faltered, bond prices often surged, cushioning overall downside and largely validating the sturdiness of the classic 60/40 model.

But as this week’s Chart illustrates, we’ve once again entered a very different environment.

The Arc of Correlation: Regime Transitions Since 1964

Historically, correlation regimes have reflected the prevailing macro regime. From 1964 to the early 2000s, stock-bond correlations were mildly positive or volatile around zero. That era was marked by bouts of high inflation, war-driven fiscal stimulus, oil shocks, and the gradual deregulation of financial markets. During the inflationary 1970s, stock and bond returns were positively correlated—meaning both could fall together, as they did in 1973–74.

The dawning of the 21st century ushered in a regime shift. As globalization and tech-driven disinflation took hold, central banks gained credibility in anchoring inflation. From roughly 2000 to 2021, the correlation turned distinctly negative. This period was a golden age for balanced portfolios. When equities sold off—think of the Great Financial Crisis (“GFC”) or the COVID shock—bonds, in particular Treasury bonds, rallied sharply. Stock and bond portfolio diversification worked quite well.

But the post-pandemic world has ushered in another correlation regime and has broken with that dynamic. Since 2022, the 24-month rolling correlation between the S&P 500 and the Bloomberg Barclays U.S. Treasury Index has soared into deeply positive territory, reaching levels not seen since the late 1990s. This reflects the return of inflation risk as a dominant macro driver.

What Drives Regime Shifts?

Shifts in correlation regimes are not random. They tend to coincide with structural macroeconomic pivots. There are three primary catalysts:

1. Inflation Volatility: Perhaps the strongest driver. Rising or unanchored inflation expectations—particularly when central banks are perceived as behind the curve—drive both bond and equity risk premia higher, increasing their correlation.

2. Real Rate Dynamics: When real interest rates rise—especially due to tightening monetary policy—both stocks and bonds can fall simultaneously. Conversely, falling real rates tend to restore the negative correlation regime.

3. Policy Credibility: The perceived ability of central banks to suppress inflation without crushing growth impacts the market’s correlation structure. During the “Volcker disinflation,” for example, stocks and bonds diverged significantly as rate hikes crushed inflation expectations but preserved long-term growth potential.

Implications for Diversification: What Now Diversifies Equity Risk?

In positive correlation regimes, bonds lose their traditional diversification role. Investors must look beyond fixed income exposure to mitigate equity drawdowns. Historically, asset classes that tend to benefit during such periods include:

• Commodities: Energy, metals, and agriculture often perform well when inflation expectations rise. Commodities have shown low or even negative correlation to both equities and bonds during inflationary periods.

• Trend-following strategies: Managed futures and Commodity Trading Advisors (“CTAs”) have historically provided positive convexity—an increasing rate of change—in both inflation and deflation shocks, as they systematically go long or short across asset classes based on price trends.

• Real assets and infrastructure: Assets with inflation-linked cash flows or pricing power—such as infrastructure equities, TIPS, and select real estate—tend to hold their ground or outperform when nominal rates rise.

• Quality/global equities: In contrast to broad equity beta, quality stocks with strong free cash flow and pricing power have exhibited relative resilience across correlation regimes.

Navigating the New Regime

Investors today may face a structural environment more reminiscent of the 1960s–1970s than the post-GFC norm. If we are in a sustained period of higher inflation volatility, asset allocators will need to diversify more broadly—across geographies, strategies, and inflation-sensitive exposures.

If, on the other hand, AI-led productivity growth and the promise of increased fiscal rectitude on the part of governments globally both take hold, we could see a return to lower stock and bond correlations. They may not return to a negative regime, but even a decline from current levels to neutral territory would greatly aid investors and asset allocators in their efforts to diversify portfolios and deliver better risk-adjusted returns.

The world is changing. The data is telling us as much. Our portfolios should reflect our increasingly dynamic world.

Sources: UBS Asset Management, Vanguard, Alpha Architect, Verdad

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