The why — diversification may be more rewarding but harder to come by
In an environment characterised by shorter and more divergent economic cycles and the accompanying market volatility, we expect increased dispersion within asset classes and greater differentiation among countries and companies. Against this backdrop, investors need flexibility and diversification in their asset allocations to adapt to changing market conditions and exploit dislocations as they arise.
In 2022 and for a significant part of 2023, the market narrative was driven largely by persistently higher inflation, forcing the major global central banks to hike interest rates. In this macro scenario, the negative returns that many fixed income assets delivered, combined with their higher correlation with equities, brought into focus the lack of adequate diversification in many portfolios’ fixed income allocations.
Despite weaker performance in higher-rate and higher-inflation environments, bonds have proved to be a strong source of portfolio diversification over the long term. We think that a diversified mix of fixed income assets has the potential to be an attractive hedge for risk assets this year, even if the relationship between equities and bonds remains unstable and correlations are persistently higher. And if inflation continues to slow, or at least plateau, our research suggests that we can expect greater divergence between equity and bond performance. Our research on US inflation, equities and bonds over the 50-year period from 1973 to 2023 also implies that the negative bond/equity correlation is stronger when inflation falls below 3%, as shown in Figure 1.