Our Chief Cross-Asset Strategist Serena Tang discusses how rising
oil prices and geopolitical tensions could make stocks and bonds
move in the same direction, challenging one of the key principles
of portfolio diversification.
Read more insights from Morgan Stanley.
----- Transcript -----
Welcome to Thoughts on the Market. I’m Serena Tang, Morgan
Stanley’s Chief Cross-Asset Strategist.
Today: what happens if your main diversification strategy
suddenly stops working because of oil price moves?
It’s Tuesday, March 10th, at 10am in New York.
For decades, investors have relied on the idea that stocks and
bonds return tend to move in opposite directions. When equities
fall, bonds often rise, helping cushion portfolio losses. But
that relationship isn’t guaranteed. Between 2021 and 2023, coming
out of the pandemic, stocks and bonds sold off together, and the
traditional 60/40 equity-bond portfolio suffered its worst annual
performance in nearly a century.
Now, recent geopolitical tensions and rising oil prices are
raising a familiar concern for investors: Could that uncertainty
dynamic return? At first glance, oil prices may seem like a
narrow commodity story. But in reality, they can shape the entire
macroeconomic environment.
The classic negative correlation between stocks and bonds depends
on a fairly simple economic pattern: growth and inflation moving
in the same direction. When economic growth accelerates,
inflation often rises as well. In that environment, equities may
perform well while bonds weaken. But when growth and inflation
move in opposite directions, the relationship between stocks and
bonds can flip. That’s what happened coming out of the pandemic.
Bond investors worried about rising inflation, while equity
investors were worried about slowing growth. In that scenario,
both asset classes' returns declined at the same time.
A sustained oil price shock could potentially recreate those
conditions. Higher oil prices can push up inflation while also
weighing on economic activity – a combination that economists
often refer to as stagflation. If markets begin to price in that
kind of environment again, the relationship between stocks and
bonds could shift back toward that less favorable regime.
Despite recent volatility tied to tensions in the Middle East,
the relationship between stocks and bonds today still largely
reflects the traditional pattern. Overall, stock-bond returns
correlation remains negative, meaning bonds can still help
diversify equity risk. In fact, correlations between U.S. stocks
and 2-year Treasury returns have been trending negative since
2024, and on a longer-term basis they are now extremely negative
relative to the past three years. But the key point here is that
not all bonds behave the same way.
Many investors think of government bonds as a single asset class.
But the maturity of the bond – how long it takes to repay –
matters a lot for diversification. Shorter-dated bonds, such as
2-year U.S. Treasuries, have maintained stronger negative
correlations with equities. Longer-dated bonds, however –
particularly the 30-year Treasury – have behaved a bit
differently. Their correlation with stocks has been stickier and
less negative, partly because markets increasingly view
longer-dated bonds as risky. As a result, the difference between
how 2-year and 30-year Treasuries move relative to stocks has
remained unusually wide for several years.
In recent days oil prices have been rising -- linked in part to
concerns around the Strait of Hormuz. That’s pushing up yields at
the front end of the Treasury curve, creating what’s known as a
bear-flattening. In other words, short-term interest rates are
rising faster than long-term ones, reflecting markets placing
more emphasis on inflation risks. And that brings us to the key
questions for investors: Which risks will dominate from here – is
it going to be higher inflation or slower growth? The answer
could determine which assets provide better diversifications in
the months ahead.
So the takeaway is this: Higher oil prices and geopolitical risks
could increase the chances that stocks and bonds move together
again. But diversification isn’t disappearing. It’s just becoming
more nuanced. For investors, the real question isn’t whether
bonds diversify portfolios. It’s which bonds do.
Thanks for listening. If you enjoy the show, please leave us a
review wherever you listen and share Thoughts on the Market with
a friend or colleague today.
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