Stocks and bonds have long been considered two sides of the same coin in investment portfolios. However, recent trends suggest a growing divergence between these asset classes. According to Pacific Investment Management Co. (Pimco), this presents an interesting opportunity for investors to adjust their allocations and potentially enhance returns.
Reviving the Inverse Relationship
As price pressures ease and the growth of the US economy slows, the inverse relationship between equities and bonds has made a comeback. Pimco portfolio managers Erin Browne and Emmanuel Sharef note in a report that "the stock/bond correlation tends to turn lower and then negative as inflation and GDP growth moderate, as is the case in the US and many other major economies today." This means that while stocks may be experiencing a rally, bonds can still provide stability and act as a hedge against market volatility.For example, the Bloomberg US Aggregate Index has gained 1.6% this year through Tuesday, while the S&P 500 Index has soared 24% in 2024. This shows that investors can benefit from a diversified portfolio that includes both stocks and bonds. "Equities and bonds can complement each other in portfolio construction, and both are likely to benefit in our baseline economic outlook for a soft landing amid continued central bank rate cuts," Browne and Sharef add.The Federal Reserve's cutting cycle has also played a role in this trend. The Fed kicked off its cutting cycle with a half-point reduction in September and then lowered rates by another quarter percentage point earlier this month. Swaps traders are assigning about a 50-50 chance that the US central bank will cut rates again in December as policymakers try to navigate slowing growth without tipping the economy into a recession.In a soft landing scenario, US equities typically gain into and through the first rate cut but then taper off three months after. Bond returns, on the other hand, have been positive when the Fed was easing in various economic backdrops. This highlights the potential for diversification and the ability to manage risk through a combination of stocks and bonds.Portfolio Allocation Strategies
For its multi-asset portfolios, Pimco, a California-based firm, favors a slight overweight to the US for stocks and a bias for high-quality core bonds. This typically includes investment-grade debt. In equities, investors should focus on US companies with earnings that don't rely heavily on imports, given President-elect Donald Trump's plans to raise tariffs. Trump has proposed raising tariffs to 60% on goods imported from China and to 20% on items from other countries. The asset manager views firms that are set to benefit from the new administration's planned tax cuts and looser regulation as good portfolio additions.Investors can increase their allocations to risk assets in a bid for higher returns "with the potential for adding little to no additional volatility within the overall portfolio," Browne and Sharef write. The surge in yields ahead of and following Trump's election win, as well as Republicans gaining control of both Houses of Congress, has bumped rates up to an attractive range. "An allocation to inflation-linked bonds or other real assets could help hedge against the potential risks of increasing inflationary pressures arising from fiscal policy or tariffs," Browne and Sharef say.The benchmark 10-year Treasury yield hovered at about 4.4% on Wednesday, up over three-quarters of a percentage point from its low this year of 3.6% reached in mid-September. Real rates, as gauged by the yield on US 10-year inflation-protected securities (TIPS), have jumped to just over 2% from about 1.5% in early October. A lower or negative stock/bond correlation allows for complementary and more diversified cross-asset positioning, especially for those with access to leverage.