Bonds are not the diversifiers of equities that many investors think they are. In this week’s Perspectives, Fund Manager Anthony Rayner looks at when bonds have acted as good diversifiers and what has worked in the extended periods when bonds have failed to diversify.
Starting from first principles, diversification is about ensuring enough elements in the portfolio behave in different enough ways across most probable scenarios. In most multi asset portfolios, equity risk will be the dominant risk, and so it is about ensuring enough of the portfolio is diversifying equity risk.
If there’s one word that best describes the Macro Thematic team’s philosophy, it’s pragmatism. We think it’s very important in all areas of investment, but particularly so when looking at diversifiers. For example, many investors believe that developed government bonds are the best diversifiers of equities over time. However, this is simply not the case. As the graph below shows, over 50 years, there are indeed extended periods when US government bonds do diversify US equities very efficiently but, for a roughly equal amount of time, they are positively correlated with US equities.
US equity and US Treasury bond correlations
Source: S&P 500 Index, 31.12.1974 – 23.10.2024, Bloomberg Finance L.P.
However, all is not lost, there are other diversifiers out there, for those that are prepared to look. The second graph shows that in most of the periods where bonds are positively correlated to equities, commodities act as good diversifiers of equity.
US equity and commodity correlations
Source: S&P 500 Index, 28.09.1973 – 23.10.2024, Bloomberg Finance L.P.
There are many good reasons for the changing dynamic as to what best diversifies equities but, digging into the data, one of the main drivers is inflation. When inflation is not a key risk, as in most of the last three decades, central banks can cut rates in the event of an equity market correction, to mitigate the impact on the wider economy, and this benefits bonds as equities correct, hence their diversifying power in that period.
However, the disinflationary period of the last 30 years is not typical. Normally, or during the 20th century at least, economic history is characterised by inflation. In this environment, often inflation is either the key risk or an important background risk, so central banks can’t afford to cut rates during an equity market correction, doubly so if inflation is the cause of the correction (which it often has been).
So, whilst bonds do not act as diversifiers to equities in periods of inflation, other asset classes do. The second chart shows how, during inflationary periods, commodities come into their own and help diversify equity risk.
We’re not saying that it will always be either commodities or bonds and we’re not even saying we will know what will best diversify equity. We are saying, though, that we should expect diversifiers to change as the environment changes: looking at the real world, and what is going on in the here and now is crucial.
This approach informs how we are structuring portfolios currently. We believe that, whilst inflation has fallen sharply, for many structural reasons it will likely reaccelerate in the medium term to levels that are uncomfortable for central banks. As a result, we have some bonds in the portfolios for income, but also to diversify equity risk, but we also have some commodities, such as gold. Within equities we are also pretty diversified away from the key concentration risk of big tech, where we have limited exposure. As visibility improves around the inflation picture, so we will adjust portfolios.
