Ultimately, today’s investing landscape demands that we re-think diversification …
With the return of inflation and spiralling levels of government debt, many investors are questioning whether bonds will still provide a life-raft in times of market turbulence. And if not, how should one construct a diversified, balanced portfolio?
There is no question that investors face a more challenging diversification problem than during the pre-pandemic period. Back then, a portfolio balanced between stocks and bonds fared well whatever the conditions. Equities provided capital growth in good times, while government bonds rose in value when recession hit and central banks cut rates.
The post-pandemic reality is more complex. Investors need protection from recession risk, but also from inflation shocks and fiscal largesse that have the potential to cause both bond and stock prices to fall. Bonds are no longer the one-size-fits-all solution they once were. Investors today need different life-rafts for different storms.
Government bonds for recessions, but be selective
Government bonds have undoubtedly had a difficult few years. Fears about inflation and excessive government spending have contributed to a level of rates volatility that, as we write, has even outstripped that seen in stock markets. No wonder investors are questioning the safe haven properties of their government bond holdings.
However, it’s important to recognise that in recent years the predominant economic risk has been the risk of overheating, caused in part by generous fiscal payouts. As we look forward to 2025, risks are more evenly balanced.
As the US economy cools, it is possible that geopolitical tensions cause a loss of confidence and lead to recession. In this scenario, we would expect bonds to once again diversify against equity losses. Indeed, bonds have already demonstrated their worth when recessionary fears arise. During the equity market sell-off over the summer of 2024, bonds exhibited their more typical offsetting characteristics. US equities fell by 8.4% from 16 July to 5 August, while US 10-year Treasuries delivered positive returns of 3.2%.
Given the starting level of yields, the ability of bonds to protect against a deep recessionary shock is actually greater than it has been in a long time. If 10-year government bond yields were to fall by 100 basis points over the next 12 months, they would deliver a return of more than 10% (Exhibit 26). This performance would provide the kind of meaningful diversification against equity losses that multi-asset investors rely on when constructing balanced portfolios.
There are, however, nuances for investors to consider when deciding where to allocate their duration budget. Investors naturally tend to gravitate towards bonds with higher yields, given the more attractive income on offer. But for diversification purposes the size of the move in yields matters far more than the starting point (Exhibit 26). Investors should therefore focus on identifying markets where either inflation or fiscal risks are unlikely to hamper the ability of bond yields to fall.
Exhibit 26: Government bonds will provide protection in a recessionary shock
Government bond return scenarios
%, total return over 12 months
Source: LSEG Datastream, J.P. Morgan Asset Management. The chart indicates the calculated total return achieved by purchasing government bonds at current yields and selling in 12 months’ time given various changes in yield. For illustrative purposes only. Past performance is not a reliable indicator of current and future results. Data as of 12 November 2024.
We prefer German Bunds on both accounts. Cyclically, the inflation backdrop appears more benign, and we have more confidence that the European Central Bank will be cutting rates meaningfully in 2025. The European Commission’s oversight of fiscal policy provides an institutional guardrail that is attractive for government bond investors. And on aggregate, eurozone debt to GDP is expected to remain lower on a relative basis (Exhibit 27). But reaching fiscal objectives looks politically challenging in more indebted eurozone countries such as France and Italy. We have more confidence in the ability of German Bunds to insulate a portfolio than Gilts or Treasuries.
Exhibit 27: US debt is on an unsustainable path
Government debt
% of nominal GDP
Source: Bank for International Settlements, Eurostat, IMF, LSEG Datastream, J.P. Morgan Asset Management. Debt refers to gross debt at face value. The dotted lines represent IMF forecasts. Data as of 12 November 2024.
Alternative assets for inflation and fiscal shocks
While pandemic-related inflationary pressures should continue to subside in the near term, we expect that over the medium term a more fragmented global economy – and the potential for fiscal misbehaviour – will give rise to more inflationary impulses similar to those experienced in 2022. In this case, fixed income assets might be expected to experience a sell-off at the same time as stock prices are falling (Exhibit 28).
Exhibit 28: Alternatives offer protection from inflation
Selected asset class returns, 2022
%, total return in USD
Source: Bloomberg, HRFI, MSCI, NCREIF, LSEG Datastream, S&P Global, J.P. Morgan Asset Management. Commodities: Bloomberg Commodities Index; Global government bonds: Bloomberg Global Aggregate – Sovereign; Hedge funds: HRFI global macro; US core real estate: NCREIF Property Index – Open End Diversified Core Equity component; Europe core real estate: MSCI Global Property Fund Index – Continental Europe; Global infrastructure: MSCI Global Quarterly Infrastructure Asset Index (equal-weighted blend); Timber: NCREIF Timberland Total Return Index. Transport returns are derived from a J.P. Morgan Asset Management Index. Past performance is not a reliable indicator of current and future results. Data as of 12 November 2024.
This expectation underscores the importance of broadening diversification strategies beyond traditional bonds. In an environment characterised by two-sided risks, real assets emerge as a vital component of a well-rounded portfolio. These assets, which include real estate, infrastructure, transport and commodities, provide a hedge against inflation, offering protection when conventional safe havens are scarce. Their intrinsic value and tangible nature make them less susceptible to the erosive effects of rising prices, thereby maintaining purchasing power and protecting real returns during inflationary periods.
Beyond real assets, other alternatives can also play a crucial role in diversification. By allocating a portion of a portfolio to strategies designed to generate returns irrespective of market conditions, investors can further enhance portfolio resilience. Hedge funds, with their diverse strategies such as long/short equity, event driven and global macro, can capture value in various environments. By actively managing exposures and being flexible in changing market conditions, hedge funds can mitigate losses and limit downside risks in portfolios (Exhibit 29).
Exhibit 29: Hedge funds can provide downside protection
Selected asset class returns in bear markets
%, total return in USD
Source: Bloomberg, HFRI, LSEG Datastream, MCSI, J.P. Morgan Asset Management. 2000 bear market is from 31 March 2000 to 31 October 2002; 2008 bear market is from 31 October 2007 to 28 February 2009; 2022 is calendar year. Global equities: MSCI World; Global bonds: Bloomberg Global Aggregate index; Global macro hedge funds are as defined in the HFRI hedge fund strategy classification system. Past performance is not a reliable indicator of current and future results. Data as of 12 November 2024.
Gold may also rise in value during inflationary episodes, as investors seek to store value in an asset that is limited in supply. Indeed, gold has performed well over the last two years, but in “normal times” gold is a zero-yielding asset – so we would argue that other real assets provide a better source of protection through the cycle. For example, since 1981 US real estate has outperformed gold 60% of the time on a rolling three-year basis, and has delivered three times the total return.
Ultimately, investors need to re-think diversification in today’s investing landscape. A portfolio needs to incorporate core bonds for income and recession protection, but also inflation-sensitive real assets and hedge funds. While we maintain a constructive view on fixed income, a broader approach to diversification allows investors to build more resilient portfolios well-equipped to navigate the complexities and uncertainties of today’s global economy.