Oil Rally Tests Diversification Strategy

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 10:00 a.m. 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 decline 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 towards that less favorable regime.