Are 60/40 portfolios still diversified as correlations rise?

The short answer is no. It's unfortunate that many investors may have viewed 2022 as an anomaly, but history tells us that stocks and bonds can become correlated, and respecting the macro regime that leads to this is key, and it has almost everything to do with inflation.

Our research shows that as inflation rises, real returns in a traditional 60/40 portfolio tend to begin to suffer. That stands to reason, as inflation erodes an investor's purchasing power. But at levels of inflation at or above 3%, stocks and bonds become more positively correlated. Even though U.S. inflation has cooled significantly since its post-COVID highs, it has not reached central bank targets of 2% or remained contained at or below that level.

Source: Robert Shiller, Sterling Professor of Econimics, Yale University, http://www.econ.vale.edu/~shiller/data.htm. “Stocks” refers to S&P 500 Index. ”Bonds” refers to US 10-year Treasury Yields. “60/40 Portfolio” refers to a hypothetical portfolio comprised of 60% U.S equities, and 40% U.S. fixed income. Return for the 60/40 Portfolio has been calculated based on the weighted, monthly, historical returns of the S&P 500 Index blended with the weighted, monthly, historical returns of US 10-Year Treasury Yields for the period from January 1,1940, to December 31, 2025.

Add in massive geopolitical factors such as war, energy security and deglobalization, all of which raise the specter that inflation will likely remain stubbornly above central bank targets. This is on top of tariffs that are largely still in place, a retreat from globalization and its disinflationary trade dynamics, and other factors that contribute to higher baseline price inflation. There is also a currency debasement element to inflation, which is likely a topic for another time. Suffice to say, inflation is much more a factor for consumers today than it has been for decades. There is equal concern for investors, and the importance of stock/bond correlation could take time to sink in for those with habit-formed portfolios.

Which Asset Class Suffers Most?

When painting with two colours in a traditional long-only 60/40 allocation, it's not so much about which asset class suffers the most, but rather which suffers more than expected. The focus is squarely on bonds. In growth shocks, bonds have tended to provide sufficient ballast against the downside in stocks, but in inflation shocks, they typically fail to serve as a diversifier to equity risk.

This highlights the significant opportunity to complement a traditional portfolio with an allocation to alternative assets and strategies that seek to create diversification on two planes.

• First and foremost, we believe that adding new diversifiers in the form of uncorrelated alpha strategies is the primary imperative. Uncorrelated strategies do not rely on the level and direction of interest rates or developed market equity risk, (two factors that almost fully explain the returns in traditional 60/40 portfolios) leaving ample opportunity to diversify these risks.

• Second, rather than be frustrated by the unpredictable nature of inflation, investors may consider harnessing inflation-linked returns through an intentional allocation to a thoughtful and properly diversified set of inflation-sensitive returns, where a combination of different asset classes and new strategies can help investors play offense when inflation is weighing on the 60/40.