Evolving correlations: Rethinking diversification

Geoeconomic uncertainty is disrupting structural market dynamics and forcing investors to take a more forward-looking, multifaceted approach to diversification.

Higher yields and stronger nominal total return prospects are enticing investors back into bond markets, but not without risk. Sticky price pressures and structural forces like demographics and deglobalisation (including tariffs) are keeping inflation above target in some jurisdictions, limiting scope for rate cuts. Meanwhile, concerns about debt sustainability have increased as macroeconomic uncertainty and fiscal profligacy are being accompanied by reduced demand for Treasuries from price-insensitive buyers such as central banks, resulting in higher and more volatile term premia. The relationship between market risk and interest rates has therefore evolved.

These dynamics have significant implications for asset allocation strategies, particularly when it comes to finding low and negatively correlated sources of return to diversify portfolios. Historical asset class correlations are no longer serving as reliable anchors for the future.

Against this backdrop, investors should consider embracing a broader toolkit to add stability to portfolios, including traditional and alternative investments with differentiated risk-return profiles (Figure 2). Even within asset classes and regions, investors should work to improve the stability of their portfolios, taking active decisions to combat current elevated levels of concentration risk.

Figure 2: Diversification has become more complex

Fortunately, there are many asset classes from which to choose (Figure 3). The key is to identify and incorporate strategies with differentiated return drivers that can deliver diversification benefits by complementing a portfolio’s existing construction. This means assets that can deliver returns that are negatively correlated with those of either equity or fixed income through the cycle.

It is important to note that disruption associated with geoeconomic fragmentation means that what has worked in the past might not necessarily continue to work in the future. Constantly evolving market dynamics will require investors to assess each prospective portfolio component from a forward-looking perspective, in context of their portfolio and the prevailing market backdrop.

Figure 3: Asset class correlations versus US equities and Treasuries

Past performance does not predict future returns.

^{Source: Fidelity International, FMRCo, May 2025. Five-year correlations against S&P 500 Index and Long-term Treasuries, weekly data. Additional equity markets represented by MSCI indices, Fixed income by Bloomberg indices, other data from HFRX.}

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