The End of Easy Diversification

If your mental view of how investments work was formed in the last 25 years, you may need to think again. Why? Because the signs are that the traditional equity/bond portfolio – a model of diversification designed to protect against market volatility – no longer works.

To explain yesterday’s model, equities and bonds were generally thought to be uncorrelated, meaning their prices moved in opposite directions. In market shocks, when equities fell in price bonds would rise, cushioning overall investment portfolios.

Yet in 2022 this form of diversification stopped working. Surging global inflation hit equities and bonds together. The S&P 500 fell roughly 18% on the year, and a classic 60/40 portfolio — 60% equities, 40% bonds — lost 15.5%, one of its five worst calendar years since 1871. More defensive mixes fared even worse relative to their history: a 50/50 and a 40/60 portfolio each recorded their second-worst year on record, surpassed only by 1931. The supposedly safer the allocation, the more surprising the loss — because the bonds meant to cushion the fall were falling too.

In fact, over the last century the years from 2000-2021 of negative equity/bond correlations when diversification worked were an anomaly, coinciding with a long period of disinflation. Before that correlations between equities and bonds were positive in inflationary times and negative only in the briefer periods when inflation was low and stable (see chart).

Negative equity-bond correlations are not normal

Notes: Five-year rolling equity-bond correlation against five-year smoothed consumer price index (CPI) inflation, post-1900¹.

After two decades of disinflation, 2022 appears to be when the economic regime changed. It heralded a shift to a period like the post-World War II years of 1946-1953, when inflation spiked, or the 1970s energy crises. In both eras, inflationary spikes triggered simultaneous losses in equities and bonds.

Three Forces Driving Enduring Inflation

While the reversal of the demographic dividend that suppressed labor’s wages is the chief reason for today’s higher and likely longer lasting inflation, it’s reinforced by others. The three forces underpinning inflation are:

1. Demographic reversal. From the 1980s to the 2010s, the ‘baby boomer’ generation, born in the post-World War II baby boom, was joined by China's massive labor pool. This ample labor supply suppressed wages and goods inflation, anchoring the equity-bond architecture. But that dynamic is reversing as working-age populations shrink in the developed world and much of East Asia. The developed world has seen high dependency before — in the post-war baby boom — but that was youth dependency, a future workforce in waiting that went on to suppress wages for decades. Today's is old-age dependency: a shrinking workforce that pushes the other way, toward higher wages and prices.

Aging baby boomers grow dependent on younger workers

Youth dependency (0–14 / 15–64) versus old-age dependency (65+ / 15–64) for Europe and North America. Source: UN World Population Prospects 2024.

2. Fiscal dominance. Aging populations are locking in entitlement spending that cannot easily be cut. Across the developed world — the US, France, Germany, the euro area as a whole — governments are running large deficits even outside recessions, with national debts at post-World War II peaks. As higher refinancing rates push interest payments up as a share of revenue and begin to threaten sovereign solvency, central banks become reluctant to raise rates, further stoking inflation.

Governments run large deficits as a percentage of GDP

General government deficit/surplus, % of GDP

General government deficits as % of GDP, selected developed economies. Source: OECD National Accounts (B9S13). Elevated deficits persist even outside recessions across both major developed-market blocs.

3. Multipolar fragmentation. In a world where governments are using economic and trade tools to geopolitical ends, the global trading system is fragmenting. Trade tariffs, export controls on strategic technologies, and near-shoring of critical inputs act as a structural tax on corporate margins and push up input prices. Again, this fragmentation is inflationary.

Trade policy uncertainty rises

Trade policy uncertainty by decade, average of the monthly Federal Reserve Board TPU index. Source: Caldara, Iacoviello, Molligo, Prestipino and Raffo (2019), Federal Reserve Board; VanEck calculations. The 2020s average is roughly five times the 2000s.

Fresh Thinking Beyond Bonds

This move from disinflation to inflation means the days of easy portfolio diversification are over. You can still diversify portfolios to cushion them against the risks of market falls but doing so requires a wider spread of assets.

The equity-bond portfolio does not have to disappear — but both parts need rebuilding, with assets chosen deliberately for their ability to weather the conditions ahead rather than the ones behind us. The core of the portfolio remains broad equities and bonds, prized for their liquidity and low cost. But even within the core, composition matters: equal-weighted or dividend-tilted equity reduces the concentration now embedded in standard capitalization-weighted indexes, and a bond sleeve has to be built for the roles it can still play rather than assumed to diversify on its own.

The greatest potential for protection, however, lies in the portfolio’s satellite, which both diversifies and drives returns. The genuine diversifiers are real and hard assets — gold, silver, and broad commodities — together with, for example, defense equities that have behaved similarly. Our research shows all four moved differently from mainstream equity indices and held their value across both the post-World War II inflationary years and the 1970s energy crises.

Alongside them sit return-drivers — the companies producing metals and commodities, such as miners, and stocks associated with the structural-growth themes of the energy transition and semiconductors, where today’s rising demand is meeting constrained supply. These add real return rather than protection, and the balance between the two shifts with an investor's time horizon.

Fresh thinking is required as the past few decades of easy diversification come to an end. In the months to come, we will offer more insights on how to structure portfolios for these more inflationary times.