Key takeaways
- Markets are currently being driven more by how assets react to news flow than by the events themselves, with price action and correlations sending clearer signals than headlines
- Traditional diversification is under pressure, as equities, bonds and gold can sell off together during periods of stress
- A more volatile, supply-driven inflation environment is leading to less stable and often positive correlations between asset classes
- Portfolio construction needs to be more deliberate and multi-layered, combining different sources of resilience rather than relying on a single hedge
- Structural growth drivers, particularly AI and infrastructure investment, are shaping the cycle, outweighing short-term geopolitical noise
- Investors should expect a more uneven and less comfortable return path, requiring portfolios built for resilience over time, not smooth outcomes
If you’re sitting in front of your computer right now, it probably feels like markets are being driven by whatever the latest headline happens to be. One day it’s oil, the next it’s geopolitics, and in between you’ve got correlations that don’t behave the way the textbooks say they should.
Stepping back, what matters more is how markets are reacting to all of this, not just the events themselves.
The recent escalation in the Middle East is a good example. The price action initially looked familiar enough. Energy moved higher, equities sold off, and risk came out of portfolios. But very quickly, something more uncomfortable emerged. The usual diversifiers did not diversify. Bonds sold off alongside equities. Gold did not provide the protection many would have expected. Correlations moved together, and there were very few places to hide.
That is not just a short-term anomaly. It speaks to something more structural that is worth thinking about in how you build portfolios from here.
For a long time, most asset allocation frameworks have relied on the idea that bonds will offset equity risk. But if you take a longer historical view, that negative correlation is not actually the norm. It has really been a feature of the low and stable inflation environment we experienced from the mid-1980s onwards. If you believe, as we do, that we are now in a world where inflation is more volatile and driven by supply-side forces such as energy and geopolitics, then it is reasonable to expect correlations to be more unstable and often positive.
In practical terms, there is no single replacement for what bonds have done over the past few decades. Diversification becomes more deliberate and, frankly, more demanding. You need to think in layers. High-quality equities that can hold up better in drawdowns. Selective contrarian exposures that are less crowded. Dynamic option strategies that can provide more explicit protection. A measured allocation to liquid alternatives. None of these solve the problem on their own, but together they improve resilience when the traditional offsets fail.
The other point that tends to get lost in periods like this is time horizon. These events feel all-consuming when you are in them, but markets have a track record of working through geopolitical shocks relatively quickly. Even energy-led conflicts tend to be absorbed within months rather than years. That does not make the path smooth, but it does argue against reacting in a way that materially reduces long-term return potential.
At the same time, it is worth keeping sight of what is actually driving the cycle, because it is not the headlines.
The strength we have seen in US equities, particularly in technology, comes back to earnings and the nature of this expansion. This is not a consumer-led cycle. It is an investment-led one. The build-out of AI infrastructure and the capital expenditure that sits behind it is the dominant force. That is a very different dynamic to what most of us have been used to.
It means you can see some softening in employment data without necessarily undermining growth. It means that capital spending becomes a more important driver than consumption. And from an allocation perspective, it shifts the focus towards the enablers of that system. Energy, electrification, grid infrastructure, industrial capacity. These are not traditionally the centre of the cycle, but they are increasingly where the return opportunities are coming from.
Regionally, that shows up quite clearly. The US continues to benefit from that investment dynamic. Japan is interesting from a domestic recovery perspective, particularly in areas tied to internal growth and financials. Europe is more complicated given its exposure to energy. And for those of you allocating to Australia, the linkage to natural resources is an important support, particularly in an environment where supply-side constraints remain a feature.
The key risk, of course, is that the current conflict persists for longer than expected. If that happens, the scenario shifts. You move closer to a stagflationary outcome where growth weakens and inflation remains elevated. In that environment, you could see bonds start to regain some defensive characteristics, but for a different reason. Markets would be responding to the growth shock rather than the inflation impulse.
We are not there yet, but it is the scenario that needs to be monitored as you think about portfolio protection and the amount of risk you are prepared to carry.
When I distil this down for portfolios, there are a few things I would focus on.
First, do not let short-term headlines dictate long-term asset allocation. They matter, but they rarely define the direction of the cycle.
Second, revisit diversification with fresh eyes. If your assumptions are still anchored in the last 30 years, there is a risk you are underestimating how correlations behave in stress.
Third, stay anchored to the structural drivers, particularly the investment cycle tied to AI and infrastructure. That is where a significant part of the opportunity set is emerging.
And finally, accept that the path will be less comfortable. There will be periods where diversification does not work the way you expect. The aim is not to eliminate that, but to construct portfolios that can withstand it and still deliver over time.
