04 May 2023 5 min read

Diversification: Looking back, to move forwards

By Chris Franklin , Tim Armitage

Bonds and equities are moving in different directions again. But can this negative correlation last, and what does it mean for multi-asset investors?


In the first blog in our series on diversification, John Roe covered regret risks and hindsight bias. It could be easy to look back at last year through this lens. Marred by rampant inflation and extreme geopolitical turmoil, 2022 was an ‘annus horribilis’ for investors. In a year where there were few places to hide, multi-asset portfolios were not spared from negative returns.

2023 has seen the welcome return of negative correlations between bonds and equities. To look forward, however, we think it is important to reflect on 2022’s challenges for diversified strategies. If the relationship between bonds and equities remains unstable, we believe it could pay to keep faith in multi-asset portfolios that are more broadly diversified for the years ahead.

A broken life raft

 That bonds tend to outperform when equity markets decline has been observed in every previous equity bear market going back to the 1970s. High-quality bonds have historically acted as a life raft for multi-asset investors, often delivering positive returns even as equity markets tumble[1]. This has been incredibly valuable for investors, smoothing portfolio returns and buffering the temptation to withdraw money from markets, just at the point when downtrodden equity valuations imply better forward-looking return potential.

But 2022 was clearly very different, with most asset classes down over the year and bonds some of the worst performers. The year saw both stocks and bonds produce negative returns for just the second time in 50 years, and it was one of the worst years in history for the traditional 60/40 portfolio. So, what happened?


The perfect storm

We have previously talked about the pitfalls of placing too much weight on inflation forecasts, given the difficulties in forecasting its path. Nonetheless, the consensus narrative among investors as we started 2022 was one of cautious optimism that pandemic-related supply chain disruptions would ease, inflation would be transitory, and the global economy would normalise. However, the invasion of Ukraine by Russia shattered this hopeful consensus. This led to levels of inflation which have not been seen in a generation[2]. It was this inflation and the synchronised response of central banks, raising interest rates to combat inflation, which broke the negative correlation between equity and bond returns[3].

Unlike previous equity bear markets, the driving force behind 2022’s market declines was not a global economy that was too ‘cold’, but rather one which was too ‘hot’, with central bankers raising interest rates to cool demand in the economy. Higher interest rates led bond markets to reprice, as markets demanded a higher yield from fixed income, while also providing an adverse environment for equities.

We don’t believe in throwing out the bond baby with the inflation bathwater. Treasury yields have fallen during 17 out of the past 18 US recessions, and in the wake of the banking stress in March 2023, the negative correlation between bonds and equities has made a welcome return. 


Diversification didn’t sink

Despite poor bond returns last year, diversification offered a degree of support for investors’ portfolios but it required a deeper level of diversification than just bonds and equities. Through allocations to inflation-linked alternative asset classes like infrastructure, multi-asset investors were somewhat insulated from the worst that equity markets had to offer. Early in 2022, as part of our allocations for inflation blog, we highlighted FX exposure as a key tool for savers looking to weather 2022’s inflation surge. This proved valuable for GBP-based investors, for whom escaping the pound helped as diversified currency exposure acted as a tailwind to portfolio returns.

Foreign currencies such as the USD and euro strengthened versus sterling over the year. For example, currency effects turned a painful -19.4% decline in US equities into a more palatable -9.6% for an unhedged GBP investor[4]. Finally, diversification of bond holdings beyond gilts also helped, in part due to the idiosyncratic risks introduced by the UKs domestic politics rollercoaster. Commodities delivered the most significant short-term hedge against inflation, although we remain cautious about the benefits of the asset class for long-term investors.

This highlights the benefits of a well-constructed multi-asset strategy, which can offer greater resilience in down markets than an all-equity portfolio or the ubiquitous ‘60/40’ mix of equities and bonds. This is accomplished through exposure to all parts of the investable universe. A truly diversified approach ensures investors can always benefit from a degree of exposure to better performing parts of the market, whether it be in terms of region, asset class or currency.

Clearer skies on the horizon?

With bond yields now substantially higher than in the previous decade, investors may potentially expect a return that’s materially higher than long-term inflation expectations. We also believe it is unlikely that 2022’s ‘annus horribilis’ for investors will be repeated. Even if we see recession as a base case for the year ahead, bond yields now have room to compress in our view, and therefore potentially give portfolios a performance cushion. The long-term return prospects of multi-asset portfolios may therefore have improved, and for many investors, time in the market could be more valuable than timing the market, even if that means suffering short-term declines. 


[1] Source: Bloomberg data, LGIM calculations as at April 2023

[2] Source: IMF as at December 2022: https://www.imf.org/external/datamapper/PCPIPCH@WEO/OEMDC

[3] Source: Bloomberg data, LGIM calculations,rolling 24-month equity bond correlation, as at December 2022

[4] Source: Bloomberg data, as at December 2022

Chris Franklin

Investment Specialist

Chris is an Investment Specialist in the Asset Allocation team, primarily covering our institutional fund ranges. Chris joined LGIM after completing his MBA at the University of Cambridge. Outside the office, he is an outdoors enthusiast, always plotting the next excursion whether on a golf course, up a mountain or anything in between.

Chris Franklin

Tim Armitage

Quantitative Strategist

Tim is a former musician reincarnated as a quantitative strategist, and subsequently spends more time writing code than songs these days. When not thinking about swaption strategies and risk indicators, you’ll find him running marathons, and secretly hoping there’s a day his three sons form a band that becomes the next Kings of Leon.

Tim Armitage