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To help track the wide range of possible outcomes, we and BlackRock portfolio managers created five scenarios to map different market and economic outlooks over the next six to 12 months. Of the two scenarios where stocks sell off, we expect government bonds to provide protection in only one. Why? The long-negative correlation between stock and bond returns varies with the macro backdrop. It has turned positive amid sticky inflation – see the chart – so bonds less reliably cushion portfolios against equity selloffs. We eye other diversifiers since historical options don’t work as well. Take gold and bitcoin. Their correlation to global stocks remains limited, even with the occasional spike, making them better diversifiers than bonds in the last two years. This isn’t about replacing bonds: Today, gold and bitcoin don’t have the negative correlation bonds did but instead offer distinct sources of return.

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We think gold has diversification properties because its risk and return drivers are different than those for equity and bond returns. Investors have long turned to gold to protect their portfolios from inflation and geopolitical risks, and to act as a store of value because its limited supply preserves value over time. Gold prices have surged this year alongside the U.S. dollar – a break from their traditional inverse relationship. What’s behind that? Investors seeking to protect portfolios against higher inflation, and some central banks seeking alternatives to major reserve currencies against the backdrop of heightened geopolitical tensions. Such demand can drive returns for alternative diversifiers like gold, no matter past correlations.

The case for bitcoin

Like gold, bitcoin could appreciate over time when its predetermined supply is met with growing demand. But demand for bitcoin is based on investor belief in its potential to be more widely adopted – and is thus central to its investment case. Some potential drivers of adoption: Bitcoin is decentralized, 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. We see these factors making bitcoin more attractive in today’s world, and it could be a more diversified source of return because its value drivers are different than for traditional assets. Yet it remains highly volatile and vulnerable to sharp selloffs. And its value could tumble if it’s not widely adopted. Read more in our new paper (for professional investors).

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We stay pro-risk headed into 2025 and think the most likely near-term scenario is one where U.S. growth moderates, but corporate profits remain strong. Risks to our view include surging long-term bond yields and greater trade protectionism. Our scenarios outline other risks, such as sticky inflation spurring central banks to stop cutting rates or slowing growth. If such an outlook spurs markets to flip-flop in their pricing of interest rates, bonds may not effectively hedge against any stock selloffs. We think investors should broaden their diversification toolkits, with gold and bitcoin potentially promising additions.

Our bottom line

Bonds no longer reliably diversify portfolios across a wide range of possible outcomes and scenarios. That calls for a rethink of diversifiers. This is our last weekly commentary of 2024, and we will return on Monday, Jan. 6. Happy holidays.