Adopt a new vantage point for diversifying your portfolio

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.

Figure 1

The when — time to reassess after the storm

Global inflation is now declining from its very elevated levels but is likely to remain more volatile and structurally higher than in the past. Meanwhile, the exceptionally steep rate-hiking cycle appears to be drawing to a close. As we move out of the eye of the storm, now, in our view, is an opportune time for investors to reassess their fixed income exposure and adopt a new vantage point, not just within their overall asset mix but, equally importantly, within their fixed income allocation in order to enhance portfolio resilience and achieve their income and growth objectives. In a new regime of structurally higher inflation and greater economic uncertainty, a diversified mix of fixed income allocations could offer protection against the equity price declines that often accompany the early stages of a recession.

The how — increase the number of potential avenues 

Investors seeking a more diversified, risk-controlled fixed income exposure may wish to consider the following areas in particular:

• Higher-quality core fixed income. Decelerating inflation, rising geopolitical risks and the threat of a global recession make core fixed income, and particularly credit, strategies appear increasingly attractive from both an income and capital protection perspective because they offer a combination of yield and, unlike cash, significant upside potential in a risk-off environment. The higher dispersion across securities in this late stage of the cycle makes an active credit selection process even more important. 
  
• Total return strategies. While also including high-yield and emerging markets debt in a fixed income allocation can offer income and growth potential, these sectors are more sensitive to the economic cycle than total return strategies, which aim to earn positive total returns in any macro environment and to capitalise on bouts of macro and market volatility.
• Regional building blocks. A more divergent macro regime provides a wider opportunity set as economies move through their cycles at varied paces. Economic cycles have already become more dispersed, with Japan, for example, in a reflationary regime, Europe and the UK in a stagflationary one and China deleveraging and deflating. Interest-rate paths will also reflect this divergence. Opportunistic allocations should allow investors to lean into these divergences and participate in the most attractive country-specific stories.
• Sustainable investing. We think investing in fixed income strategies with specific sustainability objectives also has the potential to offer attractive returns. With climate-related and other sustainable challenges increasingly impacting the real economy, sustainability provides fixed income investors with an additional lens through which to manage risk and diversify exposures into new areas of innovation and growth. Specifically, through bottom-up ESG or impact research, investors are able to identify and directly finance issuers and projects promoting positive sustainable outcomes. The burgeoning market for sustainable bonds can also offer investors a direct path to investing sustainably, where they can finance specific projects and hold issuers accountable for their progress on specific sustainability metrics.
• Thematic approaches. Investors should consider using a thematic lens to diversify into areas such as impact investing and capture the winners of the associated structural trends at a sector and security level. Highly influenced by structural change, thematic investments can help to reduce the importance of the cycle and increase diversification.

Final thoughts

While we think diversifying fixed income exposure is a key component of a rewarding investment approach in this new macro regime, investors should consider it as part of a wider range of potential sources of diversification such as commodities and alternatives, including strategies that could extend the opportunity set within fixed income further. In our view, the resulting portfolio, with fixed income at its heart, optimises the potential upside from both income and growth while remaining adequately defensive in today’s more volatile world.