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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 10:00am 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, bond prices often rise, helping cushion portfolio losses. But that relationship isn't guaranteed. Between 2021 and 2023, coming out of a 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 were 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 could shift back towards 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 remain negative, meaning bonds can still help diversify equity risk. In fact, correlations between US stocks and two year treasury returns have been trending negative since 2024 and 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 two year US Treasuries have maintained stronger negative correlations with equities. Longer dated bonds, however, particularly the 30 year treasury, have behaved a bit differently. The 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 the concerns around the Strait of Hormuz. That's pushing up yields at the front end of the treasury curve, creating what's known as 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 your thoughts on the market with a friend or colleague today.
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