Diversification in the age of rising stock/bond correlations

In a well-diversified portfolio, as one asset class declines, another should rise, mitigating risk and minimizing losses. Yet that is proving to be easier said than done. As fixed income and equity markets seem to have shifted to risk-off, investors are struggling to find assets that move in the opposite direction from other assets, leaving portfolios exposed to synchronized losses even if they are diversified. Specifically, the recent performance of stocks and bonds have been moving in the same direction: down.

So how to achieve better diversification in times like these? In our view, bonds are still a reliable diversifier in a market rotation, especially as we get late in the business cycle. Better balancing risk exposure in a bond portfolio is critical to realizing the benefits of diversification.

As it stands, investors basically have two choices. They might find short rates extremely attractive, primarily for income generation, but that approach will be limited in its ability to provide a counterbalance in the event of a tail-risk event. The alternative is to assume longer-duration exposure with a tilt towards interest rate risk, which would provide diversification against a growth slowdown as well as an insurance policy against a tail-risk event.

For those reasons, we are constructive on the bond market. We see it priced appropriately, with a bias toward downside risks as higher rates bite into debt-laden consumers’ ability to spend. We continue to believe the Bank of Canada and the U.S. Federal Reserve are likely to take a pause in the tightening cycle early in 2019, as growth cools and inflation expectations remain well anchored. Going forward, we expect a flatter yield curve, monetary tightening and a corresponding liquidity drain, and positive front-end rates to persist into the late cycle, creating more volatility in risk assets.

If that turns out to be the case, then benchmark duration in fixed income can help to diversify a portfolio.

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