Thinking more broadly about portfolio diversification

The bottom line is investors need to think more broadly about portfolio diversification, accounting for solutions that work in disinflationary scenarios (government bonds) but also diversification that could work in more inflationary scenarios, where stocks and bonds could fall together as they did in 2022.

2022 was a challenging year for investors as stocks and bonds fell together, posting one of the worst returns on record for a traditional 60/40 portfolio. There have only been three occasions in the last 50 years when US stocks and bonds both lost money. Those were: 1969, when US inflation breached 6%; 1974, when inflation reached 12% on the back of the oil crisis; and 2022, when inflation suddenly reached 40-year highs.

As we look forward, there are a number of plausible economic scenarios. One is that a recession arrives with enough force to quickly eradicate inflation concerns. This scenario might send tremors through risk markets, but we are now in a position where bonds can diversify deep recession risk in a way that they struggled to do in a low yield world. The rise in bond yields is one of the reasons we became so much more positive on fixed income last year.

However, there is another potential scenario whereby inflation remains problematic; one in which recession is avoided in the near term and inflation pressures don’t sustainably subside. In this scenario, the cuts in interest rates that are already priced in by bond markets may not materialise and rates could rise further. As a result, bonds – and quite possibly also stocks - could struggle.

We also see a reasonably high likelihood of above-target inflation remaining a challenge over the medium term. This is due to a scarcity of various things, not least workers, which have previously been abundant. The bottom line is investors need to think more broadly about portfolio diversification, accounting for solutions that work in disinflationary recessionary scenarios (government bonds) but also diversification that could work in more inflationary scenarios, where stocks and bonds could fall together as they did in 2022.

Alternative diversifiers

Unlike stocks and bonds, many alternative asset classes – including timber, infrastructure and real estate – managed to generate positive returns last year.

These asset classes are generally decent inflation hedges as they can often pass through higher inflation via higher rents or usage costs. To be clear, parts of real estate could come under further pressure in a higher rate environment, particularly those parts facing structural challenges. But alternative assets, such as infrastructure, could continue to prove relatively defensive while also providing some inflation protection and an attractive income. Hedge funds have also historically done a decent job of limiting drawdowns relative to equity markets in periods where equities (and bonds) struggle.

With the potential for more inflation volatility over the coming years, one may not be able to rely on a consistent negative correlation between stocks and bonds to limit portfolio downside and improve risk-adjusted returns. So, while our base case sees government bonds providing some portfolio diversification if stocks were to fall in the near term, investors might want to look beyond traditional asset classes to further diversify their portfolios.

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