Diversification in the era of Trump

The US stock rally and an unnerving start to Trump 2.0 mean it’s time to talk about diversification. Traditional diversifiers - government bonds - may not be the answer this time though. But an array of alternatives is available to investors, some hidden in plain sight.

27 February 2025

The base case scenario for global stocks generally, but US stocks in particular, since the November election has centred on the idea that tax cuts and deregulation will propel the US economy and, by extension, the US stock market too. The prospect of both policies coming about remains broadly intact. Whatever you may think of its methods, the new Department of Government Efficiency (DOGE) seems likely to succeed in shrinking the US government and the enormous 100,000-page Code of Federal Regulations. Tax cuts in the form of renewing the previous 2017 Tax Cuts and Jobs Act (TCJA) while also removing taxes from social security, overtime and tips will require passage through Congress but seem likely to happen. So far so good.

MAGA moves could put the Fed in a bind

But recent weeks have also seen a slew of policy announcements which are giving investors pause on whether the economic benefits described might end up being undermined. Mass deportations and tariffs are inflationary by nature and could inadvertently force the US Federal Reserve into outright tightening of monetary policy (ie higher interest rates), hitting consumer confidence, economic growth and ultimately corporate earnings. Combine this with the fact that the S&P 500 Index has already delivered an extraordinary return of nearly 77%* from end September 2022 to 17 February 2025, and investors could be forgiven for starting to think more seriously about portfolio diversification. As the godfather of the concept Harry Markowitz, the Nobel Prize-winning American economist best known for developing Modern Portfolio Theory (MPT), demonstrated, a well-diversified portfolio can potentially achieve rates of return similar to a concentrated portfolio but with less volatility. Right now that sounds rather appealing but while the theory is sound, putting it into practice has become harder recently for reasons that will become apparent. Regardless, investors should still be able to select from a range of potential diversifying strategies that should prove effective in this latest Trump era.

The 60:40 conundrum - correlations in the new tech-led investment era

When most investors think about asset class diversification they tend to think in terms of classic multi-asset combinations like the 60:40 portfolio combining large cap stocks with long-dated government (and possibly also corporate) bonds. In the US at least such a strategy fared well from the early 1980s up to 2022 as stock prices appreciated consistently, with some exceptions such as during the technology bubble unwind of the early 2000s, the Global Financial Crisis of 2008 and the Covid-19 pandemic. US Treasury bonds also played their part as yields fell (and prices rose) to reflect the ‘Great Moderation’ in inflation and the apparent role of central banking in this achievement. But the underlying conditions that supported the 60:40 approach have been changing, and the same combination could prove inadequate in future. 2022 saw both stocks and bonds falter simultaneously amid the onset of war in Ukraine and resurgent inflation. Indeed, while inflation in the US has been cooling since October 2022, it has actually stopped doing so more recently, and the latest print in January 2025 reported a 3%* headline rate of Consumer Price Index (CPI) inflation. This has cast further doubts about the longer-term inflation outlook which was already keeping bond yields elevated and pushing down prices on many investors’ favourite diversification tool. And it comes at a time of increased uncertainty for stocks following a period of outsized gains, as described. Concerns about the new US administration’s policies and how (or whether) they will be implemented have combined with perceived competitive threats from Chinese artificial intelligence (AI) technology such as DeepSeek. For multi-asset investors, this emerging trend of two previously independent asset classes starting to share risks in common is something to be wary of (see chart below). High correlations over time negate the very point of combining stocks with government bonds to produce diversification, and could end up achieving the very opposite.

Stop copying me - stocks and bonds are starting to synchronise:

12m rolling correlation from 31 Dec 1999 to 18 Feb 2025

A blend of old and new solutions to achieve diversification

Interpreting this as the death of Markowitz’s concept is probably too dramatic. Instead, investors need to consider effective alternatives, which do exist. In recent weeks, there has been a flood of interest in so-called ‘zero-day’ options contracts (options that expire on the same day they are traded on)tied to the S&P 500, along with volatility-based hedging instruments (tools like futures and options contracts specifically aimed at helping investors manage and mitigate risks associated with changes in market volatility). However, these are not always practical to implement and can incur significant costs if used over time in a multi-asset portfolio. Instead, other, easier-to-implement diversifiers can be brought to bear. One source of simple and effective diversification lies hidden in plain sight. Today the three-month US Treasury bill, a short-term US government debt security that matures in three months, offers an annualised yield of over 4.2%* with virtually no interest rate or default risk (these securities are widely seen as the safest in existence given they are backed by the faith and credit of the US government) associated with it. Similarly, so-called ultrashort-dated (generally under 12 months to maturity) high quality investment grade corporate bonds, as measured by the Markit iBoxx USD Liquid Investment Grade Ultrashort Index, offer a yield of nearly 4.6%* with an extremely low probability of underlying company default. Investors worried that these yields cannot possibly last can take some comfort from the very uncertainty that is undermining longer-dated government bonds, ie inflation. With inflation stubbornly high as described, the US interest rate which drives short-dated bond yields could stay higher for longer than anticipated. But even if that proves not to be the case, there are other effective further avenues to pursue. Alternative investment strategies including macro and FX investing, or even just simply tracking the returns offered by the hedge fund universe more generally, can potentially provide diversification at crucial moments (see chart below). And then of course there are physical commodities. Gold, for example, has long been a hedge against inflation and uncertainty, but has shown itself to be increasingly effective during major crises since 2008. Furthermore, it enjoys a unique form of support: the US Treasury holds 8,133 metric tons* of gold reserves officially valued at the somewhat archaic level of USD 42 per ounce (market prices today are not far off USD 3,000*). Any upward revaluation of the Treasury’s stash could propel prices further, as long as they do not then choose to dump it on the market. Other compelling examples abound but the point is clear – there is more to diversification than long-dated government bonds.

Per the tin – alternative investments offer a potential solution to the diversification challenge:

From 31 Jan 2001 to 19 Feb 2025

Investing in the era of Trump the disruptor

The second Trump era represents a dizzying combination of great promise but also great uncertainty. Trying to formulate an organising framework around all the policy pronouncements is almost futile but there is much investors can do to better prepare their portfolios. Within equities, shifting regional and style allocations is certainly valid but true diversification in the multi-asset context demands optimum use of asset classes beyond equities since few equity markets will escape unscathed from any future correction in US stocks. Today, the old stalwarts in the form of long-dated government bonds may not be able to fulfil this diversifying role amid growing correlation to stocks and an uncertain inflation and economic policy outlook which is keeping yields elevated (and prices down). But, to borrow from actor Michael Caine’s philosophy of ‘using the difficulty’, shorter-dated bonds carry advantages precisely because of these conditions. Appealing and consistent real (inflation-adjusted) yields can be had without the directional uncertainty longer-dated bonds inevitably bring. And beyond these, a rich world of alternatives, including specialist trading strategies and gold, is open to those willing to do the homework. Investors can therefore be confident that diversification today is just as achievable as during the golden age of the 60:40 portfolio. This is especially reassuring because it is rapidly becoming clear that the uncertainty and volatility of the last few weeks is not a bug, but a deliberate policy feature of the new US administration.

Julian Howard is Chief Multi-Asset Investment Strategist at GAM Investments.