Multi asset: is the tide turning for bond allocations?

The performance of bonds has been uninspiring in recent years, and the asset class has consequently taken a back seat in many asset allocations. Yet, as inflation moderates, central banks cut interest rates and US economic policy generates trade uncertainty, the investment case for bonds appears to be improving. This Q4 issue of Simply put examines the evolving investment landscape to ask if bonds should play a greater structural role in portfolios once more. 

The CIO’s perspective: just enough bonds to perform

Since December 2020, the meagre performance of global bond indices has raised the question: why bother about bonds at all? 

While not necessarily forecasting a comeback for bonds, we believe that bonds remain fundamental to well-diversified multi-asset strategies, as they continue to serve the key functions of diversification and income. As shown in Figure 1, long-term aggregate bond performance oscillates around returns of equity. There are three distinct periods when equities significantly outperformed aggregate bonds: 

1.	During the equity boom preceding the 1929 crash
2.	Amid the technology bubble of 1999-2000 and
3.	Throughout the inflationary shock of the 1970s.

These episodes offer interesting historical parallels to today's environment – particularly in the US, with its retail investor-driven enthusiasm for growth stocks and persistent inflation concerns. Each of the subsequent periods illustrates the value of bonds, underlining our belief that bond market exposures may once again prove valuable in properly diversified portfolios.

FIG 1. Performance of US asset classes over the long term¹

It's crucial to remember that bonds tend to be most valuable during challenging investment periods. They deliver substantial benefits during equity downturns without historically imposing significant costs on performance. This asymmetric risk-reward profile underscores why bonds remain essential components in portfolio construction, regardless of recent performance trends. 

While we are not declaring a golden age for bonds, we suggest that the current pessimism surrounding them is likely misplaced.

Read more: Multi asset: resilience in a V-shaped market recovery

Portfolio positioning: back to neutral

Portfolio managers worldwide have faced the same tariff-driven sequence of market swings since April 2025. Ultimately, tariffs have proven to have had very limited market impact. The apparent innocuity of tariffs is precisely where we see the strengths in our investment style of staying disciplined and trusting the process. We have progressively increased our market exposure and managed to reclaim some lost ground. This repositioning has been executed without sacrificing diversification; we continue to balance cyclical assets with diversifiers. 

A quick tour of our indicators offers a comprehensive perspective on what's currently at stake. Risk measures are now normalising from elevated levels. Global equity risk has effectively normalised, with parallel patterns observable across inflation, credit and commodities risk premia. By quarter end, even bonds approached their ‘median value’ and would likely require minimal catalysts – perhaps several Fed rate cuts – to drive further downward. For now, this gradual recalibration continues and could substantiate our strategic repositioning toward bonds during the fourth quarter.

Trend signals suggest bonds are vulnerable, which is consistent with the persistent inflation and fiscal pressures currently weighing on fixed income markets. Risk appetite remains consistently robust across all components at present; meanwhile, valuation metrics place equities on the pricier side of the spectrum and bonds at the inexpensive end. Finally, macro signals currently offer little directional guidance and could remain uncertain for the remainder of the year. 

In all, these investment indicators are not signalling a time for bold action, but maintaining a steady course. This particularly applies to our bond exposure, which has returned to a neutral stance. 

Macro: how low can rates go?

Monetary policy seems to have reclaimed its dominant position in financial markets. The Federal Reserve (Fed) has emerged as the most significant market driver, even surpassing the recent enthusiasm for the technology sector. This shift carries profound implications for both bond and equity markets, as duration effects substantially influence market trajectories. 

For the Fed, interest rate cuts now appear to be the only viable path forward. In determining how low Fed rates might go, we apply the Taylor Rule – a monetary policy guideline that prescribes how central banks should adjust interest rates in response to economic conditions, specifically inflation and the output gap. 

Figure 2 presents our in-house estimate of a standard Taylor Rule for the Fed over an extended timeframe, utilising two distinct estimation periods: 1950-1995 and 1995-2025. This dual approach accounts for the significant shift in Fed preferences after the Volcker era. These calculations suggest that the appropriate Federal Funds rate should be 3.35% – notably lower than current levels. 

FIG 2. Estimated Fed Taylor Rule² 

 
Yet, much depends on inflation. If US inflation rapidly retreats toward 2.5%, Fed rates could swiftly decline to 3% or below. However, should inflation prove more persistent, this decline would likely be limited. Currently, our nowcasting signals suggest a moderate yield decline as the more probable scenario – although, like Chairman Powell, we maintain a strictly data-dependent outlook.

Simply put, for Fed rates to come down to around 3%, inflation needs to show signs of a medium-term normalisation.

Read more: Don’t fight the Fed – it’s the main driver of US bond yields

Special focus: what bonds can do to diversification

Bonds have experienced treacherous times in recent years. Rather than their traditional negative correlation to equities, bonds have been positively correlated to equities and, therefore, have offered limited diversification. Yet, this tide seems to be turning. 

This improvement in diversification appears to be part of a broader shift. One significant challenge over the past four years stemmed from how bond futures’ dynamics constrained their diversification contribution. As inflation rose, central banks implemented rate hikes to combat this. The factor driving global bond futures – the global level – gained importance. This concentration within the bond market signalled reduced diversification potential not only relative to other asset classes but also within fixed income itself. 

Recently, however, this dominance is waning. This not only points to an improved bond contribution to overall portfolio diversification but also enhanced diversification benefits among the individual bond futures in our holdings. 

Research update: a new world of nowcasters

Given inflation pressures, recession risks and monetary policies have alternatively impacted markets since the post-COVID-19 era, building robust indicators for economic regimes is paramount. To gain a higher definition when looking at the current picture, we have developed a new set of country-specific nowcasters, which provide greater granularity compared to our previous three-economy representation of the world (the US, the eurozone and China).   

While still focusing on three economic variables – growth, inflation and monetary policy – we have broadened our scope by adding eight countries: Australia, Canada, Japan, New Zealand, Norway, Sweden, Switzerland and the UK. This addition may seem superfluous, as markets seem increasingly polarised around the US. However, in our view, small open economies provide valuable information on the contagion process of shocks from large economies to the economic system as a whole, granting a finer assessment of systemic economic risk. 

In essence, expanding the number of country-specific nowcasters can facilitate a better estimation of global economic output, but this needs to be aggregated appropriately. 

Read more: Size matters: what small countries teach us about global trade

Bonds are just one of many multi-asset diversification tools

Over the years, we have encountered one persistent misperception: that risk-managed strategies rely heavily on their bond allocation. High diversification is at the core of our philosophy – we hold multiple assets at all times, and do not allow any single asset to dominate portfolio risk. This is reinforced by our active risk modelling and rebalancing, as well as our active and controlled use of leverage. The combination of these principles creates an efficient framework for the use of bonds, as well as other assets. If bonds are reemerging as a significant diversification source, the investment case for risk-based solutions will only become considerably stronger.