Is portfolio diversification working? Q1 2024 insights

Equity markets rise despite global challenges

Q1 was a tough quarter for diversification, with many of the trends from the previous quarter persisting into the first three months of 2024. Despite shifts in anticipated interest rate cuts, geopolitical tensions, and regional economic challenges, global equity markets continued to rise in Q1, particularly within the U.S. The S&P 500 Index gained 10.6% over the quarter hitting record highs and posting its best first quarter since 2019. Four of the Magnificent 7 stocks continued their charge through the first quarter, with Nvidia (NVDA) leading the way +82%. However, the U.S. also witnessed a broader market rally beyond mega-cap technology stocks, supported by continued resilience in the economy amid strong corporate earnings and positive labor and GDP reports. As was widely expected, the Federal Reserve kept its key federal funds rate unchanged (for the fifth straight meeting) at a range of 5.25-5.50% and indicated they still expected three rate cuts in 2024. Fed Chair, Jerome Powell, stated that inflation continues to trend towards the Fed’s 2% target, but that this sometimes follows a “bumpy path,” warning that the timing of those reductions was still to be determined. The 10-year U.S. Treasury yield increased steadily from 3.88% at the end of 2023 to 4.20% by the end of March 2024, affecting various bond sectors negatively.

*Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, Bloomberg US Govt/Credit Interm TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, Bloomberg US Treasury US TIPS TR USD, Bloomberg Gbl Aggregate Ex US TR USD, JPM EMBI Global TR USD, Morningstar LSTA US LL TR USD, HFRX Global Hedge Fund.

S&P 500 Index and large cap equities see strong returns

On the equity side of the equation, most diversifying asset classes failed to keep pace with the strong returns of the S&P 500 Index and large cap equities in general, save for large cap growth stocks, specifically, with the Russell 1000 Growth Index returning 11.41%. But it's worth noting strong returns were witnessed within large cap value equities as well, with the Russell 1000 Value Index returning 8.99%, and across mid cap stocks, with the Russell Mid Cap Growth Index returning 9.50% and the Russell Mid Cap Value Index returning 8.23%. While small cap growth stocks also posted meaningful returns, small cap value stocks lagged, with the Russell 2000 Value Index returning only 2.90% compared to 7.58% for the Russell 2000 Growth Index.

Commodities also failed to keep pace with large cap equities in the first quarter, gaining only 2.19%, but have been an interesting asset class to watch from a diversification perspective over the past few years. We witnessed commodities lead asset class returns in 2021 and 2022, but post losses in 2023 when most other asset classes experienced strong gains. Energy sector ebb and flows have been top of mind for many, especially amid rising tensions in the Middle East.

The surprising rise of gold

The more interesting story may be gold’s somewhat unexpected rise to record highs in recent months. This precious metal, traditionally viewed as a safe-haven asset during periods of economic and geopolitical uncertainty, saw its price top $2,000 an ounce in Q1 2024, reaching all times highs. Gold is also widely viewed as a hedge against inflation and depreciating currencies.

Gold’s rally in recent months, however, has puzzled many because it has happened despite headwinds that should have held it back. For one, its ascent has coincided with investor optimism about the U.S economy and strong stock market performance, in contrast to previous events that pushed gold to all-time highs such as the 2008 financial crisis and the Covid-19 pandemic. And while gold is often used as a hedge against inflation, generally, higher interest rates tend to be viewed as gold’s biggest enemy with the two typically having an inverse relationship. Higher interest rates make gold, which pays no income, less attractive relative to stocks and bonds that pay interest and dividends and vice versa, making the asset class vulnerable to the current higher-for-longer monetary environment. Gold’s unorthodox rally has also atypically coincided with a strong to flat dollar.

Possible reasons for the gold rally

While some price appreciation for gold can be explained by the prospect of lower rates on the horizon and corresponding expected decrease in the value of the dollar or even the fear of sticky inflation, the intensity of the surge prior to these rates cuts actually happening is surprising. Over the past few months, gold has continued to rally, despite Fed Funds futures pricing in less rate cuts expected in 2024. Further examination reveals gold’s curious uptick appears to be driven by two additional, interrelated factors: geopolitical unrest and a substantial increase in central bank purchases, particularly from China. The increased demand for the safe-haven asset is not abnormal given the geopolitical turbulence witnessed with the Russian-Ukraine conflict and more recent conflict between Israel and Hamas, not to mention the upcoming U.S. presidential elections and ensuing potential for increased tensions between the U.S. and China were Republican president candidate Donald Trump to win. But the increased central bank purchases have been an unexpected trigger to gold price growth, with central banks, especially those of emerging market counties such as China, India, and Turkey becoming unusually aggressive buyers, buying at unprecedented levels.

More recent buying seems to be prompted by a desire to diversify away from the U.S. dollar, especially in light of U.S. imposed sanctions on Russia. Demand for gold in China has also been particularly insatiable on account of their prolonged property market crisis, volatile stock markets, and weak currency. Chinese investors have followed suit with their central bank, as demand for physical gold such as jewelry, gold bars, and gold coins have risen to record highs as well. From a high level, the recent behavior of central banks outside of the U.S. suggests an overall shift in gold market dynamics. In the context of diversification, gold’s interesting rally is a good reminder of not only the unpredictability of individual asset classes but also the ever-evolving dynamics of the factors at play for particular asset class, especially as we witness heighted economical and geopolitical changes in the world.

Varying fixed income and portfolio diversification results

Within fixed income, diversification benefits proved to be more beneficial in the first quarter. Fixed income markets struggled relative to their equity counterparts, as bond prices declined and yields rose amid concerns inflation remains high, with January and February inflation readings showing an uptick in prices (undoing the slight decline seen over the prior few months.) The Bloomberg U.S. Aggregate Bond Index returned -0.78% over the quarter, and we saw international bonds struggle even more, with the Bloomberg Global Aggregate Ex US Index returning -3.21%. Diversification, particularly within high yield, emerging market debt, and bank loans, however, was beneficial over the quarter. All three asset classes contributed positive returns in Q1. Bank loans led the way, with the Morningstar LSTA US LL Index returning 2.46% over the quarter. Short-term bonds also marginally outperformed intermediate bonds over the quarter.

At the portfolio level, diversification results continued to struggle in the first quarter. A basic 60/40 portfolio, which combines the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index, returned 5.94% in Q1 of 2024, outpacing a fully diversified portfolio, which returned 4.06%. But it can be easy to overlook or minimize the benefits of diversification on the upside, when equity markets are flying high. We are often reminded of them, however, on the downside when markets are negative. This was arguably the case in both the most recent quarter, Q3 of 2023, as well as the most recent full year, 2022, where markets produced negative returns across almost all asset classes. In the third quarter of 2023, a basic 60/40 portfolio returned -3.24%, yet a fully diversified portfolio, lost only 1.74%. Similarly, in 2022, a basic 60/40 portfolios lost 15.79%, while a diversified portfolio lost only 11.80%.

Diversification the key to navigating unpredictable financial markets

At the end of the day, whether we’re taking the 10,000 foot view of the general up or downs of markets in aggregate, or the 10 foot view of the behavior individual asset classes or sectors, we can see when it comes to financial markets, unpredictability lurks around every corner. Over the long term, diversification remains a systematic and calculated what to reduce this risk, while still allowing investors to participate in the long-term goal of capital appreciation.

By: Rachel Mandeix, Portfolio Manager