Building a diversified portfolio at a time of stagflation

  • To understand the role bonds can play in a balanced portfolio
  • Discover how thematic equities fit into overall portfolios
  • Learn about the benefits of currency exposure in a diversified portfolio
Building a diversified portfolio at a time of stagflation

Uncertainty abounds in markets. The sources of uncertainty vary from time to time, from known knowns to unknown unknowns. Ultimately investment management is about trying to deliver an outcome in the future and so is about wrestling with uncertainties to achieve a definite outcome. 

While there is always uncertainty in financial markets, portfolio construction is there to help us navigate this and offer some guiding principles for delivering robust portfolios. 

The future is impossible to predict, but we can consider the range of possible scenarios and, importantly, think about how the market appears to have priced each of the range of plausible outcomes. 

It is important to remember that a robust portfolio designed for diversification and robust outcomes will differ to a return-maximising or even a return-targeted portfolio. And this may mean allocating less to asset classes with the highest expected return, and allocating to assets that may feel uncomfortable at the time – but it is the asset classes that are the hardest to buy that are most likely to provide true diversification at times of market stress. 

Is there still a role for government bonds?

For medium and lower-risk portfolios, government bonds can still offer diversification benefits, although they may not warrant a place in return-maximising portfolios or portfolios with defined income targets. 

Despite lower yields than we have historically seen, government bonds can still offer benefits in scenarios of negative economic demand – ie. a recession or disinflationary shocks, when few other assets respond well. 

Government bonds do respond well in such scenarios, with a negative correlation to equities, which unlike most correlations often becomes more pronounced in times of stress. Many assets that are negatively correlated with equities would fall in times of severe market stress, as investors sell off everything in their portfolios in order to raise liquidity.

In such a climate, investors tend to continue to own government bonds as both a  safe haven, and a source of liquidity. 

Clearly markets are not focused on slowing demand or disinflation at present, but this is why US Treasury yields have increased by more than 1 per cent from the 2020 lows. The last couple of years have shown that the effective lower bound for government bond yields is lower than previously thought, hence there is scope for the 10-year US Treasury yield to fall by 1 per cent in a negative growth or disinflationary scenario. 

As a falling yield means a rise in the bond price, such an outcome would represent a gain for investors at a time of market stress. 

Importantly for UK investors, the cost of currency hedging has collapsed, making US Treasuries the preferred government bond market for this role.

A need to look elsewhere

Arguing for the diversification benefits of government bonds does not mean they will be great returning assets. 

Allocations should probably be lower than has been the case historically; we are now paid much less to hold this insurance asset than in previous years, and indeed we may face a negative cost under some scenarios.