One Reason Diversification Isn’t Paying Off Right Now

The Asian financial crisis and the bursting of the tech bubble in the US flipped the inflationary/deflationary axis of the economic world. The primary price concern in the world from approximately 1970-2000 was one of rising prices (i.e. inflation). Since then the world has been much more concerned with falling prices (i.e. deflation). Investors everywhere seem to be acutely aware that deflation has been the main concern since the GFC as monetary policy around the world has taken a “do anything necessary” attitude towards fighting deflation, but we feel that it is an underappreciated fact that deflationary concerns began to bubble up actually 7 years earlier. You may be wondering just how do we know that deflation has been scaring the investment world since the early aughts. One way to discern this is by looking at the correlation between stocks and bonds.

In an inflationary world, stocks and bonds move in opposite directions of one another. In theory if inflation is rising, stock prices can absorb some inflation through higher nominal corporate revenues while higher inflation expectations drive nominal bond prices lower as the purchasing power of future coupon payments declines. When deflation is the primary concern, stocks and bond yields tend to move in the same direction as we have seen over the past several years. In the first chart below we show the four-year rolling correlation between US stocks and US 10-year treasuries yields. It is very easy to see the flip in pricing concerns around the year 2000. The four-year rolling correlation went from -58% to 39% in just 5 years. Outside a brief period right before the GFC, this relationship has remained positive for the past 15 years.

This all leads us to the current environment. In the very short-term, this positive relationship has completely flipped. This is why it feels as if diversification is hard to come by at the moment. As stocks have fallen slightly, bond yields have widened out which hasn’t been the norm since 2000. The current -59% correlation over the past 22 trading days is the most negative relationship stocks and bonds have had since 2007. And since 1999, there have only been five periods where this relationship has been this negative over 22 trading days. Assuming that the world isn’t about to flip into an inflationary period, which seems like a safe bet since central banks around the world are still doing everything they can to fight deflation, then investors should start to again feel like diversification between stocks and bonds is paying off.