Inflation Regimes And Equity Correlations

Inflation of balloon from a system of aeronautics (1850) by John Wise (1808-1879)

About a year ago we wrote about Inflation Regimes and Return Distributions. The piece referenced an excellent chart we first saw from Goldman Sachs showing the Equity/Bond correlation vs realized US CPI. The negative correlation in the period since the late 1990s occurred in a world of low and stable inflation. The prior period in the chart, from 1970 to 1998 showed a period of higher than target inflation and a steadily positive correlation of stocks and bonds. Many portfolio strategies have been built with this negative correlation as the bedrock. It worked as the dual mandate acted like a single mandate on unemployment- the inflation side of the mandate could be safely ignored. Economy weakens, equity markets weaken, Fed cuts rates, bonds rally. Became self-fulfilling for a long period of time.

When inflation came back with a vengeance driven by pandemic supply chains getting overwhelmed with fiscal and monetary stimulus, then exacerbated by geopolitics and war, stocks and bonds fell together, partly as the starting point for yields was so low and durations so high. It depends exactly where you draw your lines, but long duration bonds – a diversifying asset relied upon to cushion equity markets – hit a drawdown approaching 50%. Traditional portfolios, built on that bedrock regime, only had one side of the distribution in one asset class to help diversify stocks – positive bond returns.

We contend that Managed Futures strategies have more tools at their disposal which makes them particularly well suited for changing times and inflationary periods. The long side of bonds certainly can be valuable and likely will be again at some point. But so is the short side of bonds. Add in long and short exposures in currency markets to capture things like large moves in USDJPY or EURUSD and then direct commodity exposure through long and short positions in commodity markets and you get a more complete toolbox. The proof of the pudding is in the eating, in 2022 as bonds fell hard, Managed Futures strategies performed well.

Portfolio construction relies on uncorrelated assets – preferably negatively correlated in times of stress. We have updated the chart in the aforementioned blog to include data points since 2022, noted in red. Possibly a return to the 1973 to 1998 regime- higher inflation environment, and positive stock bond correlation.

Source: FRED (US CPI Urban Consumers YoY NSA), Bloomberg (S&P 500, Bloomberg US Treasury Total Return Unhedged USD)

How about some of the other assets investors look to as inflation protection? Like gold… looks like it moved from largely uncorrelated in the past 25 years to a medium positive correlation in higher inflation.

Source: FRED (US CPI Urban Consumers YoY NSA), Bloomberg (S&P 500, S&P GSCI Gold Index Total Return)

How about TIPS – they have inflation protection baked right into the name… We have a shorter period here as TIPS launched in the late 1990s – but not a great look. 10Y TIPS fell 16% in 2022, 2% better than stocks, and ended the year with a 60 day rolling correlation of about 0.6.

Source: FRED (US CPI Urban Consumers YoY NSA), Bloomberg (S&P 500, Bloomberg US TIPS)

And Managed Futures…correlations remained negative as stocks and bonds fell post 2022.

Source: FRED (US CPI Urban Consumers YoY NSA), Bloomberg (S&P 500), Mount Lucas (MLM Index (15V): 1973-1991, MLM Index EV (15V): 1992-9/2023)