Finding diversification in a new market regime

Key takeaways

In this article you will learn:

• How market dynamics have changed this year
• Our experts’ thoughts on this new regime
• The case for alternatives in portfolios

Diversification in a new market regime

U.S. job growth remained robust in October—a sign that months of work by policymakers was doing little to cool the labor market and inflation.

It was also a sign of a market coming to grips with a higher-for-longer rate environment.

Throughout the summer, investors questioned the Federal Reserve’s commitment to ratcheting up interest rates, allowing stocks and other risky markets to drift higher. But persistent inflation figures and Fed Chair Jerome Powell’s hawkish messages have since forced a reckoning: the prolonged era of easy money and low yields is ending, and how investors diversify portfolios and generate returns is also getting upended.

Rising rates make it more likely that both the stock and bond markets will continue to be choppy, as investors discount future profits by companies, and high inflation erodes returns from fixed income investments.

This could weaken the diversification properties historically offered by owning both stocks and bonds, according to Michael Gates, portfolio manager for BlackRock’s suite of Target Allocation funds and model portfolios. From 2000-2021, the correlation of Treasuries to stocks was negative. But in 2022, it turned positive. While there is potential for correlations to turn negative again if inflation falls back down, Gates believes it is unlikely to fall to its previous levels.

Correlation of bond and equity returns since 1970

Gates believes all of this should be a tailwind for diversifying alternative investments that can offset volatility and deliver uncorrelated returns. For instance, Tom Becker, portfolio manager of BlackRock’s Tactical Opportunities Fund, is spotting opportunities because of divergence across global economies and the varying central bank policies in response.

“We try to capitalize on dispersion across countries,” he said. His team is essentially going long countries where inflation is low and central banks are easing, and short in places where inflation is high and central banks are hawkish.

Another force at play that’s been underappreciated is fiscal policy, according to him. “We’ve had austerity in fiscal policy for two decades... Covid changed everything on that front. We had direct stimulus--cash to individuals and businesses. Now we’re talking about COLAs (cost of living adjustments). Inflation indexing is happening in emerging markets, but also in countries like the U.S., so social security is going to have a step-up. The bottom line is inflation could prove to be persistent and the diversification properties of bonds could be muted.”

Jeff Rosenberg, portfolio manager of BlackRock’s Systematic Multi-Strategy Fund, agrees that the market regime of negative stock-bond correlation may be over. The “Great Moderation”, a period of collapsing variability in growth and inflation, has given way to a substantially more volatile environment with higher inflation uncertainty and for now, a need by global central banks to move to a restrictive monetary policy stance. Inflation uncertainty undermines the diversification and hedging efficacy of duration and traditional fixed income. We believe this volatility and uncertainty will last for some time making it paramount to diversify your diversifiers.

Rosenberg believes this type of market creates winners and losers, making it important for investors to focus on dispersion and alpha. His team is leaning further into their long-short defensive equity strategy which has generated defensive alpha, or positive returns through idiosyncratic exposures in this year’s down market.

There’s really a new regime that’s defined by a supply-driven economy and the Fed and central banks catching up to expansionary fiscal policies, said Becker. Small shifts in the economy—such as refinery outages or shipping constraints, for example—may cause large moves in inflation, according to him. “It’s what we’ll be reckoning with the next couple of years.”

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