The limits of diversification

Elevated inflation is weakening the traditional stock-bond diversification benefit, so investors should diversify across a broader set of income sources and real assets.

• US equities reached record highs while the 10-year Treasury yield rose to levels last seen in 2002, and Brent crude moved back above $100, reviving inflation and Fed-tightening concerns.
• For Q3, 72 S&P 500 companies issued positive earnings guidance, versus a five-year average of 42, while earnings are expected to grow nearly 30% year on year; technology is expected to lead with roughly 65% growth.
• When inflation exceeds 2.5%-3%, stock-bond correlations have historically tended to turn positive; the five-year rolling correlation between US equities and 10-year Treasury yields is currently -0.54, versus an average of 0.28 from 2000 to 2020.
• US core PCE inflation is expected to remain above 3% this year, while higher energy prices may delay disinflation and limit the ability of government bonds to hedge an equity selloff.
• The authors favour neutral duration, alongside senior loans, selected securitised assets, carefully selected credit and private credit, while listed infrastructure and other real assets could diversify technology concentration and benefit from AI-related investment.

Takeaway: Investors should value bonds more for their higher income than for reliable downside protection until inflation moderates, while recognising that longer-duration government bonds could regain their hedging role if inflation falls and growth weakens.