Morningstar - Q3 2023 - 40

Spotlight: History
government-bond portfolio during recessionary
environments, a few time periods stand out
and are worthy of further examination. In
three recessionary periods-January 1980 to
July 1980, July 1981 to November 1982,
and July 1990 to March 1991-stocks actually
gained ground, and high-quality bonds
did, too. In other words, stock market losses
and bond market gains aren't a certainty
in every recession.
The two recessions in the early 1980s-the
so-called double-dip recession-have some of the
closest parallels with the current time frame.
The Iran-Iraq war in 1980 caused energy prices
to surge and led to broad-based inflation.
In 1980, the inflation rate increased nearly 14%.
The Federal Reserve, led by Volcker, aggressively
increased interest rates to combat soaring
prices. That caused high unemployment and two
economic contractions-a mild recession
from January 1980 to July 1980 and a deeper
one from mid-1981 through 1982.
Despite those headwinds, stocks managed to
post robust gains in 1980 and 1982. (Stocks
did post a loss in 1981, however.) Stock market
participants appeared to be looking through
the bad news to better times ahead, including an
end to rising inflation and interest rates,
as well as a recovery in economic growth. They
were also cheered by President Ronald
Reagan's tax cuts and regulatory rollbacks,
among other factors.
Navigating Recessions in Portfolios
Of course, each time period is different, and the
current economic environment is almost
certainly different from that of the early 1980s. For
one thing, the 2023 economy appears to be
resilient, even in the face of inflation and dramatic
interest-rate increases, thanks largely to the
health of the labor market.
Yet even as equity returns during recessions
are scattershot, the data suggest that high-quality
fixed-income assets are a boon to portfolios
in most recessionary environments. That
is largely due to lower yields and investors' desire
for the stability and safety of fixed income
and cash assets during periods of economic
turbulence, both of which boost bond
prices. While high-quality bonds won't diversify
equities in every market environment
(see 2022), they have historically been reliable
in periods of economic weakness.
Diversification During
Inflationary Periods
The resurgence in inflation that started in May
2021 made market conditions much more
challenging. Supply chain disruptions, a tight labor
market, the war in Ukraine, and strong economic
growth all conspired to push up inflation
from its previously benign levels. The year-overyear
change in consumer prices rose to more
than 7% by the end of 2021 and reached 9% by
mid-2022. Inflationary pressures have been
easing a bit in 2023, but inflation was still running
well above average at the end of 2022.
Higher inflation marked a sharp reversal from
the previous regime. For most of the previous
30 years, conditions were unusually tame
from an inflation perspective. Aside from a brief
increase in the mid-2000s, inflation had
generally been running well below its long-term
historical average of about 2.7%.
Cooler-than-average inflation, in turn, created
close to ideal conditions for stock/bond correlations.
With inflation mostly a nonissue, stocks and
bonds moved largely independently; in fact, rolling
three-year correlations between stocks and
bonds were consistently negative (or barely above
zero) from November 2000 through 2020.
Increasing Correlations
With those conditions now a distant memory,
it shouldn't come as a surprise that correlations
between stocks and bonds have sharply
increased. In fact, correlations between stocks
and bonds edged into positive territory
in 2021, with a correlation coefficient of
0.09 between the two asset classes for the full
year. Correlations trended up to 0.58 for
the full year in 2022, and 0.15 for the trailing
three-year period.
The recent uptrend in correlations has been
unusually dramatic but not unprecedented.
As shown in EXHIBIT 1 , the stock/bond correlation
has often been positive over multiyear periods.
For example, the trailing three-year correlation
coefficients between the two asset classes were
consistently above zero from August 1966
through August 1974. Stock/bond correlations were
also consistently positive from October 1974
until late 2000.
We also looked at correlations over specific
periods of higher inflation, generally defined as
periods when year-over-year inflation increased
by at least 5% and remained high for at least
six months.4
between stocks and bonds increased during
some but not all periods.
In general, correlations increased the most
during periods when inflation was both
high (in the double digits) and protracted (lasting
at least three years). The post-World War II
era saw an unusually high spike in inflation
(driven by the removal of wartime wage
and price controls, combined with large numbers
of troops coming home), but the increase
in consumer prices lasted only about a year.
More recently, surging economic growth
in China fueled rising consumer prices in 2007
and 2008, but inflation remained below 6%
and lasted less than a year.
The most dramatic correlation upturns took
place in the periods from February 1966 through
January 1970 (driven by low unemployment
and surging economic growth) and February 1977
through March 1980 (driven by soaring oil
prices, the oil embargo and related price shocks,
and expansionary monetary policies).
Correlations ended up in a similar range (0.26
and 0.28, respectively) in both periods.
4 Inflationary periods are based on the parameters described in Neville, H., et al. 2021. " The Best Strategies for Inflationary Times, " The Journal of Portfolio Management, Vol. 47, Issue 8 (August), PP. 8-37.
40
Morningstar Q3 2023
As shown in EXHIBIT 4 , correlations

Morningstar - Q3 2023

Table of Contents for the Digital Edition of Morningstar - Q3 2023