Cause we’re living in a geopolitical world

If Madonna’s hit song “Material Girl” from forty years ago were written by an investor in 2024 instead, the hook would likely reflect a world that is less capitalistic and more focused on geopolitics. Big changes since the 1980s also include the work-from-home model, advancements in artificial intelligence (AI), significant gains in health technology (such as MRNA tech or GLP-1), and the shift in corporate investment focus from capital expenditure (CapEx) to research & development (R&D). These changes are just as important for asset allocation decisions as are the rise of fiscal deficits and coordination of fiscal and monetary policies to support an ageing demographic and the reorientation of supply chains. The common thread between all these changes is the need for financing.

For asset allocators, the challenge of sorting through these generational megatrends is perhaps best embodied by the resultant shift in correlations across asset classes. Bonds have lost some reliability in hedging a portfolio of stocks. The stock-bond correlation has risen to decade highs (north of 80%, see related chart) after being anchored in negative territory, as scary inflation prints in the past couple of years and huge U.S. Treasury supply in late 2023 and early 2024 increasingly intertwined the performance of risky assets and the Treasury market. At the same time, the correlation between U.S. and Asian fixed income has dropped to around 0%, suggesting Asian fixed income is a reasonable diversifier for a global portfolio (see related chart) just as U.S. duration’s hedging efficacy has softened. These trends are likely to moderate from today’s extremes. However, portfolios must grapple with fiscal deficits that will continue to pressure up the stock-bond correlation and geopolitically driven desynchronized economic cycles that will pressure down the U.S.-Asia correlation within fixed income, we believe. 

Unprotective bonds in equity selloffs
U.S. stock-bond correlation, 2017-2023¹

We see the great reset in bond yields triggered by inflation fears opening a compelling opportunity for fixed income investors. They can now lock in a diversified portfolio of 6%-7% yields, just as U.S. inflation trends back toward the 2%-3% range. While notably above the U.S. Federal Reserve (Fed) target of 2%, the high end of this range still allows investors to secure a 3%-4% real yield (the nominal yield minus inflation)³. Before the Covid-19 pandemic, such a result would have required materially increasing a portfolio's volatility (risk).

We believe the current combination of high quality and high carry (the additional compensation “spread” that corporate bonds offer above the risk-free rate) in such a portfolio offers a substantial buffer against the uncertain Treasury supply and portfolio correlation. The risk-free rate refers to U.S. Treasury bonds, given the unlikely possibility of a U.S. government default. Meanwhile, the largest-ever global cash pile has been building.

Triggered by high policy rates, U.S. households alone had stashed about US$18 trillion in cash in their balance sheets last September, Fed data show. A 5.3% cash yield⁴ in the U.S. is a strong incentive to keep this cash in money market funds for now, but the biggest risk facing investors with an outsized allocation to cash is the reinvestment risk ahead of an impending easing cycle. An easing cycle refers to central banks lowering interest rates, making it more affordable to borrow money.

The opportunity to lock in historically elevated nominal and real yields may not last forever. As wise as holding cash was through 2022 and much of 2023, we believe it is time to start deploying that cash before future events, such as a rate-cutting cycle or the U.S. presidential election in November, materially shrink the opportunity set (no pun intended).