The world in general and financial markets in particular have experienced a long list of shocks in the past few years: global trade tensions; the COVID-19 crisis; massive liquidity injections and fiscal transfers to households leading to supersized demand for goods; disrupted manufacturing and supply chains; and the energy price shock.

While the resulting spikes in inflation and interest rates caused havoc in capital markets in 2022, they may well have laid the foundation for a more normal investment environment going forward.

For the past several years, only a narrow set of asset classes have offered a meaningful positive return contribution to a portfolio, typically associated with greater investment risks. In particular, return expectations from core fixed income had been meagre at best, amid a lower-for-longer interest rate environment.

Until recently, the broad consensus was that the world would have to go through a slow and gradual interest rate normalization, which would create a constant headwind for bond returns. Instead, the Band-Aid is being ripped off as interest rate tightening occurs at the fastest pace in decades, and bond yields in different currencies quickly normalise and start to offer a more attractive return outlook.

Higher inflation and rising interest rates should translate into lower prices for equities and bonds. This is because future cash flows are discounted at a higher rate. Thus, higher inflation uncertainty should trigger larger, synchronised swings in the discount rates of equities and bonds, which would result in an upward shift in the bonds-equities correlation and reduce the diversification potential of bonds.

This is indeed what we have witnessed over the past two years. In contrast, growth shocks should primarily affect equities, via a depressed earnings growth outlook and lower expected dividends. Bonds, on the contrary, may benefit from such a scenario as yields fall on the back of lower inflation expectations and ultimately looser monetary policy.

With growth risks abounding at the moment, conventional wisdom suggests that we should see a retracement of the bonds-equities correlation. The problem is that inflation uncertainty remains a concern for the immediate future, particularly against the backdrop of geopolitical tensions and the looming energy crisis.

Additionally, while inflation may eventually come off the current highs, the risks are skewed toward a protracted tightening cycle, which would lead to rising real yields. This would, in turn, prevent bond prices from rallying at a time when equities come under further pressure, limiting their diversification benefits and keeping the bonds-equities correlation at elevated levels.