Inflation, diversification and 60/40 portfolio

Inflation is rising in many parts of the world, and that means interest rates will be too high. Financial asset pricing models suggest that inflation can affect stocks and bonds alike, creating a sharing relationship with short-term interest rates. Therefore, some investors are beginning to think: will stock and bond returns start to run together, and if so, what does it mean for diversification in a balanced portfolio?

To answer this question, my colleagues and I have identified the factors that have historically driven the stock and bond co-movement over time and published our results. Stock / Bond Correlation: Rise in inflation, but not regime change. The main one among those drivers is inflation, and we have seen that moving stocks and bonds together to a degree will require much higher inflation than we would expect, which would reduce the diversification capacity of bonds in a balanced portfolio.D

Why long-term investors maintain a balanced portfolio

Understanding why many investors keep a balanced portfolio of stocks and bonds is important. Stocks act as a portfolio growth engine, a source of strong expected returns in most market environments. If they always perform better than bonds or otherwise get reassuring results, investors will have very little incentive to hold bonds. Although stock prices have risen historically over time, their trajectory has not been straight. They have endured many shocks – and several sharp contractions – along the way.

That’s where the bond comes in. That inverse return pattern helps reduce the loss of portfolio value compared to an all-stock portfolio. It helps investors adhere to a well-considered plan in a challenging return environment.

Correlation in context: Time is important

We use the term reciprocity to describe how stock and bond returns are related to each other. When returns usually move in the same direction, they are positively correlated; When they move in different directions, they are negatively related. The combination of negatively saturated assets will improve diversity by smoothing the fluctuations of portfolio asset values ​​over time. Lately, however, stock and bond returns have often moved in the same direction and are sometimes even positively correlated. But this positive correlation has occurred for a relatively short time. And, as it turns out, time is of the essence.

Short-term trends may vary; Long-term positive or negative relationships can last for decades

Comments: Long-term stock / bond correlations were mostly positive during most of the 1990s but have been negative since about 2000. It’s not uncommon for short-term relationships to be positive, but it hasn’t changed long-term negative relationships. .
Source: Vanguard, January 1, 1, 0 to July 2, 2021, based on refinitive data. The data appeared on the charts in early 1992 to reflect the end of the first 2-month rotating correlation.
Past performance is no guarantee of future income.

Like the performance of any investment, looking exclusively for a short period of time will only tell you so much. Since 2000, stock / bond correlations have grown in positive territory on numerous occasions. In the long run the relationship, however, remains negative, and we expect this pattern to continue.

What will be the inflation?

Our research has identified the primary factors that affect the stock and bond relationship from the 1950s to the present day. Of these, long-term inflation is by far the most important.

Since inflation drives stock and bond returns in the same direction, the question arises: how much inflation will it take to turn the return correlation from negative to positive? Answer: A lot.

According to our numbers, it would take an average 10-year revolving inflation 3.5%. This is not the annual inflation rate; This is more than 10 years on average. In this context, in order to reach the 3% 10-year average soon, say, over the next five years, we need to maintain our annual core inflation rate of 5.7%. In contrast, we expect core inflation to be around 2.6% in 2022, taking the average to just 1.8% 10 years later.

You can read more about our U.S. inflation outlook in our recent paper Inflation Machine: What it is and where it is going. The Federal Reserve, in an effort to ensure price stability, targets 2% average annual inflation, below which we believe any meaningful period will create a positive relationship. This is well below the rate of inflation in the pre-2000 era, which averaged 5.3% from 1950 to 1999 and was associated with positive long-term stock / bond correlations.

Positive correlation requires high inflation

Chart project 2-month rolling stock / bond correlation, which is ten years behind from 2021 to 20311 in different conditions of inflation.  ;  2.5% average ten year back inflation will result in a negative 0.14 correlation;  3% average ten year back inflation will result in a 0.25 correlation;  And 3.5% of the ten-year average inflation will correlate to an average of 0.36.
Note: The figure shows Vanguard’s estimates for the stock-bond correlation in four scenarios for 10-year inflation from April 2021 to December 2025.
Source: Vanguard.

Asset allocation, more than reciprocity, affects portfolio results

What does this mean for a traditional 60% stock / 40% bond portfolio? For investors who find itching to adjust their portfolios in preparation for stock / bond correlation changes, we can say, “Not so fast.” In the portfolio simulation environment that we tested, the positive vs. negative relationships affected the measurement of fluctuations of portfolio values, such as volatility and maximum decline, in time but had little effect on the range of long-term portfolio results. What’s more, we’ve found that a portfolio’s asset allocation has shifted from 60% to 80% which leads to more significant changes in the portfolio’s risk profile than the remaining 60/40 of the portfolio when a correlation changes.

This is consistent with something you’ve heard before: portfolio results are primarily determined by the allocation of strategic assets to investors. And that’s good news, because with the right planning, investors with a balanced portfolio need to be determined to meet their goals rather than jumping off the road.

D Wu, Boyu (Daniel), Ph.D., Beatrice Yeo, CFA, Kevin J. DiCiurcio, CFA, and Qian Wang, Ph.D., 2021. Stock-bond correlation: Rise in inflation, but not regime change. Valley Forge, PA: The Vanguard Group, Inc.

Important information:

All investments are at risk, including the potential loss of money you invest. Be aware that fluctuations in financial markets and other factors can reduce the value of your account. There is no guarantee that any specific asset allocation or combination of funds will meet your investment objectives or give you a certain income level.

Past performance does not guarantee future results.

In a diversified portfolio, profits from some investments can help offset losses from others. However, diversity does not guarantee gains or protect against losses.

Investing in bonds is subject to interest rates, credit and inflation risk.

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