In our regular market webinars ‘Let’s Talk Markets’ we’re asking our audience what topics they want more information on. This month, they chose ‘Asset Class Correlations’.
The importance of Asset Class Correlations
History shows that asset class correlations are crucial if we want to enhance diversification and help reduce portfolio volatility - but they don’t always behave predictably.
Take 2022, for instance. The negative correlation between equities and bonds broke down in a rising inflation and interest rate environment. The chart below shows the relationship between US large cap equities against US government bonds. When the lines go above zero this means that the two asset classes are positively correlated and when they are below zero they are negatively correlated. Having largely been negatively correlated for the previous 20 years, the relationship between bonds and equities turned positive in 2022.
Source: JP Morgan AM, August 2024
Some critics were quick to call time on the traditional 60/40 portfolio during that time, but it’s worth remembering that correlations aren’t constant. As with moving markets and changing economic conditions, correlations between different assets can ebb and flow so it’s not uncommon to see correlations between bonds and equities change during different macroeconomic regimes.
Even when bond-equity correlations turn positive, portfolios can still offer diversification. Indeed, there are different parts of the bond market which can offer different opportunity sets. For example, government bonds such as US Treasuries and UK Gilts can perform differently if both markets are at a different phase in their economic cycles. The duration and maturity of these bonds can also offer different opportunities. There are also different types of credits within investment grade and high yield bonds which offer a variety of opportunities and risks. Each of these sub asset classes can be combined carefully to offer the right level of risk and return depending on what an investor is looking for.
Mix it up
Of course, if we add global equities to the mix this also offers further diversification. We understand that global equity markets are arguably highly correlated with one another, but there are also key differences within them. For example, emerging markets can behave differently to developed markets as they’re in a different growth phase and therefore offer different risks and returns.
Similarly, diversification can be achieved by blending investment styles like growth and value, or by combining large cap stocks with mid and small caps. The chart below shows us which assets perform well during periods of rising yields, such as value stocks and small caps, and which don’t, such as growth stocks and large caps.
Source: JP Morgan AM, August 2024
But it’s not about choosing one over the other. By having a portfolio with a balanced approach to equities and bonds, growth and value styles, large and small caps and even alternatives should offer varying degrees of correlations over time, and therefore a better chance of delivering greater consistency in risk adjusted returns.
Practical takeaways
Even when correlations shift, resilient portfolios can be built by diversifying across a mix of asset classes—stocks, bonds, growth, value, large caps, small caps, and alternatives. The key is staying flexible and adapting to changing market conditions.
Diversification isn’t dead; it’s just evolving.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.
