13 Feb 2024 2 min read

Diversification: The name of the game

By Matthew Rees

Has the positive correlation between bonds and equities over the last two years further strengthened the call for portfolio diversification?


The following is an extract from our Q1 Active Insights publication.

With the benefit of hindsight, 2023 ended as it began, with many investors being wrong-footed. At the beginning of the year, we anticipated a recession that never came. At the end of 2023, fears over sticky inflation seemed to disappear into the ether as inflation numbers fell further, and faster, than anyone had dared imagine. The US Federal Reserve (Fed) pivoted, analysts rearranged their dots regarding the Fed funds rate, and for much of the year, investors once again witnessed something they had dreaded in 2022 – the return of a positive correlation between bonds and equities.

Widening the net

It’s becoming increasingly evident that a traditional 60/40 portfolio structure is waning in popularity and that diversification needs to be found by looking at other sources. Increasingly, we believe investors are typically turning to absolute return bond strategies as a means of extracting uncorrelated returns. Absolute return strategies have no benchmark and aim to produce positive returns in all market environments with their managers’ skills.


Where do we go from here? Recession in the Eurozone?

At the time of writing, investors continue to believe in a soft-landing narrative, certainly in the US. The taming of inflation, without incurring a sharp drop in growth, would indeed be an optimal outcome for market participants. This is already reflected in US credit spreads, though, where strong inflows into fixed income have also contributed to the rally that started in the fourth quarter of 2023. But in Europe, and Germany in particular, we are already witnessing recessionary conditions. Although European spreads are wider than in the US, reflecting the weaker economic conditions, we don’t believe that the possibility of a sharp European recession is sufficiently reflected in spreads. If these were to meaningfully reprice, due to a resurgence in recessionary expectations, then we are reasonably confident that government bond yields would go down, thus potentially offsetting losses from credit.

Implications for investors

If this scenario were to materialise, we would argue that there is still value in holding corporate bonds rather than cash. The reduction in government bond yields would produce positive returns from duration, while also reducing the rates of return on cash. If a meaningful widening of credit spreads does indeed occur, we would focus our efforts on the riskier parts of fixed-income markets, such as global high yield and emerging market debt, which tend, in our view, to reprice more quickly than developed market investment-grade corporates.

The above is an extract from our Q1 Active Insights publication.

Matthew Rees

Head of Global Bond Strategies

Matthew is head of the global bond strategies team, responsible for a team focused on a range of benchmarked and absolute return strategies. When he’s not plugged into his Bloomberg screen, he can often be found on a hockey pitch where he (just about) still runs around playing as well as coaching a number of junior hockey teams. This is a role he believes has prepared him more for tumultuous markets and adults than his 25 years of experience since qualifying as a chartered accountant in the mid 1990s.

Matthew Rees