Do bonds and equities still offer enough diversification?

It is not unusual to see equity prices rising despite interest rate rises, as inflation is typically caused by excess demand allowing companies to expand their revenues, says Richard Garland, investment strategy consultant at Omnis Investments.

“This is a useful feature for multi-asset investors, because it results in negative co-movement and a diversification benefit when combining bonds and equities in a portfolio.”

Falling interest rates similarly increase the present value of future cash flows, resulting in positive returns for bonds, he adds.

“But as this usually happens during periods of economic weakness, the negative pressure on corporate earnings can outweigh the positive effect of falling interest rates, resulting in falling equity prices and again sending bond and equity prices in the opposite direction.”

The positive correlation between equities and bonds has hurt the traditional 60/40 portfolio.John Leiper, Titan Asset Management

Recent positive correlation between the two asset classes, however, meant their nature to offset each other was watered down. Indeed, Garland says it follows that an “especially toxic” environment for multi-asset portfolios is one of rising interest rates and inflation that are not associated with rising economic growth.

“Bonds and equities falling at the same time is problematic for multi-asset portfolios, but there’s no need to panic,” he adds. “Normal service will be resumed shortly.”

John Leiper, chief investment officer at Titan Asset Management, likewise says the positive correlation between equities and bonds has hurt the traditional 60/40 portfolio, particularly throughout much of last year.

“Our solution to that, at the time, was to seek safety in alternative uncorrelated strategies less subject to the vagaries of sky-high and evolving inflation.

“Coming out of Covid, when inflation started to pick up pace, oil futures had turned negative and the reflation trade was ‘on’, exposure to broad-based commodities made good sense.

There is still merit to the role of government bonds as a portfolio diversifier.Tom Delic, Momentum 

“However, when the rate of change in inflation turned negative, and disinflationary expectations started to rise, commodities proved less effective. We sold cyclical exposure but retained exposure to precious metals, specifically gold, which has held up well on an absolute basis and relative to bonds.”

At Momentum Global Investment Management, portfolio manager Tom Delic says the investment manager has for many years been concerned about the commonly held view that the inverse relationship between high-quality fixed income and equities is one that cannot be sustained.

“As a direct result of central bank policy behaviour over the past four decades, this view reached its extremes in 2020, when extraordinary zero interest rate policy pushed government bond yields to all-time lows.

“When long-term government debt was yielding sub-1 per cent in 2020, how further could yields fall to protect investors during periods of negative equity returns? This meant the probability of negative correlation remaining intact between the two asset classes was low.”

But Delic says there is still merit to the role of government bonds as a portfolio diversifier. “Their safe haven status is often valuable during short, sharp market shocks, which can dampen volatility.”