Government bonds are no longer enough to protect multi-asset portfolios during downturns, according to strategists at the BlackRock Investment Institute.
“Bonds no longer reliably diversify portfolios across a wide range of possible outcomes and scenarios,” the strategists said in a recent note. “That calls for a rethink of diversifiers.”
Typically, bonds and equities have been negatively correlated, allowing multi-asset investors to better weather market volatility. When stocks sold off, bonds would usually rally, and vice versa.
But when inflation spiked in 2022 and interest rates were ratcheted up to combat it, both the stock market and the bond market fell simultaneously, marking the first time since 1977 that bonds did not cushion investors from an equity market sell-off.
Now with inflation seemingly in the rear view mirror and more interest rate cuts being the overwhelming consensus, bonds and stocks appear to be negatively correlated again.
But the strategists at BlackRock believe economies are undergoing a transformation which could shift the long-term economic trend and potentially create a wide range of outcomes.
“Government bonds have become a less reliable cushion against risk asset selloffs in this new regime,” they said.
“So investors should consider new diversifiers like gold and Bitcoin – not to replace bonds, but to get exposure to distinct drivers of risk and return.”
When considering the outlook for 2025 and forecasting potential scenarios where stocks sold off, the strategists said government bonds only provided protection in one of their scenarios.
The reason for this was because “the long-negative correlation between stock and bond returns varies with the macro backdrop,” they explained.
“It has turned positive amid sticky inflation…so bonds less reliably cushion portfolios against equity selloffs. We eye other diversifiers since historical options don’t work as well.”
Gold and bitcoin as alternatives
Although BlackRock’s base case scenario for next year is one of strong US growth and corporate profits, they warned that sticky inflation could spur central banks to stop cutting rates.
“If such an outlook spurs markets to flip-flop in their pricing of interest rates, bonds may not effectively hedge against any stock selloffs,” the strategists said.
“We think investors should broaden their diversification toolkits, with gold and bitcoin potentially promising additions.”
The strategists said gold and bitcoin have had limited correlation to global stocks over the past two years, “making them better diversifiers than bonds” over that period.
“This isn’t about replacing bonds,” they said. “Today, gold and bitcoin don’t have the negative correlation bonds did but instead offer distinct sources of return.”
They argue that gold has unique diversification properties because its risk and return drivers differ from that of gold.
While gold has a long history of being a hedge against both inflation and geopolitical risks, more recently central banks have been buying up the precious metal against a backdrop of growing geopolitical tensions.
“Such demand can drive returns for alternative diversifiers like gold, no matter past correlations,” the strategists said.
When it comes to bitcoin, they point to its fixed supply and potentially growing demand as the primary driver of return.
“Demand for bitcoin is based on investor belief in its potential to be more widely adopted – and is thus central to its investment case,” they said.
“Some potential drivers of adoption: bitcoin is decentralised, with no direct government ability to change supply.”
“It’s also perceived to be immune from the effects of persistent government budget deficits, rising debt and higher inflation eroding the value of sovereign currencies.”
They believe this makes Bitcoin more attractive and “a more diversified source of return because its value drivers are different than for traditional assets”.
However, the strategists warned that it remains highly volatile and vulnerable to sharp sell offs, especially if it is not widely adopted.
BlackRock launched its first spot Bitcoin ETF earlier this year, which has grown to more than $50 billion in assets.
