In my letter, I cover:

• Diversification at centre stage

Further highlighted by market volatility in the wake of escalation in the Middle East, the traditional defensive role of bonds is vulnerable, necessitating a more nuanced and diversified risk management approach.

• Alternative assets and portfolio resilience

Gold and ‘liquid alternatives’ typically behave differently to traditional asset types and could offer support against market volatility and geopolitical uncertainties.

• Compelling growth prospects in emerging markets

Being precise about our equity market choices could capture the beneficiaries of economic expansion and create access to key technology themes.

The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term needs. This article should not be taken as advice.

Dear reader,

Since the launch of US and Israeli military strikes against Iran on 28 February, financial markets have been volatile. Asset prices have oscillated over the past week, as investors attempt to price this evolving situation. As with all conflicts, our thoughts are with all those affected.

As we wrote in a recent Middle East update, geopolitical upheaval can come at a very heavy price for the individuals and populations involved. However, in modern history, geopolitical flashpoints have rarely had a lasting impact on financial markets.

Nevertheless, this escalation in the Middle East provides a timely reminder of the importance of diversification within an investment portfolio.

In my March letter, I’m bringing diversification into the spotlight. Towards the end of my letter, I’ll also set some of our core market views into the context of the situation in the Middle East. 

Turning our eyes to the market stage

One thing that you may not know about me is that I am an admirer of Shakespeare, and, as Shakespeare famously told us, “all the world’s a stage.” Investment markets certainly know how to put on a show. But which assets are the stars, and which are the supporting players?

Shakespeare is thought to have produced many of his most famous works, from Hamlet to Macbeth, in the 1600s – the same century in which Coutts was founded. Angela Burdett-Coutts, the great Victorian philanthropist and patron of the arts, owned a rare ‘First Folio’ edition of the Bard’s works. She kept it inside a carved casket, made of oak wood gifted to her by Queen Victoria.

Today, I’m writing to you from the Strand, close to where Shakespeare’s plays were first performed. Inspired by the Bard, I’m musing on the winning formula for a cast of characters in an investment portfolio.

Pomp, and circumstance 

In my view, equities have often held the starring role on the market stage. Equity decisions are the exciting choices, the riskier positions designed to drive financial returns over the long run. They’re also the decisions that we tend to discuss most often with our customers.

However, in multi-asset investment portfolios, if we turn some assets into stars, we must hold others in supporting roles.

My investment team and I have maintained our pro-risk investment choices – being ‘overweight’ equities – for more than two years. Most recently, this has meant increasing our exposure to emerging market (EM) equities, where we see the most attractive growth opportunities and increasing exposure to the artificial intelligence (AI) theme.

We’ve funded our overweight in equities – and our recent preference for EM in particular – with one of our quieter, but very deliberate, decisions: maintaining an underweight position in government bonds. This also reflects our wider, cautious view on fixed income assets.

Two factors underpin this underweight position. First, our analysis indicates that prospective returns on government bonds are challenged in an environment of stronger growth, structurally higher inflation, and large fiscal deficits. Second, and arguably more importantly, high correlation between the performances of equity and bond markets has weakened government bonds’ historically reliable defensive qualities.

Let me take each factor in turn.

Exit, pursued by a bear steepening

Stronger economic growth typically boosts returns from equity markets, but it heightens the likelihood of persistently higher inflation. In turn, this erodes ‘real’ returns (i.e. returns adjusted for inflation) on bonds, as bonds are generally fixed-rate investments.

Inflation isn’t the only issue for bonds in an environment of economic expansion. One of the core drivers of economic growth is government spending, and the resulting larger fiscal deficits means that more government bonds are issued and require buyers.

This increase in the market supply of government bonds, at a time when central banks are less inclined to suppress yields through quantitative easing policies (i.e. central bank bond buying), puts downward pressure on bond returns.

In this vein, we are keeping a close eye on volatility across the yield curve – the relationship between bond yields and their maturities. Issuing more short‑maturity debt can help keep government funding costs down, but longer‑dated yields (10–30 years), which reflect investor expectations for inflation, growth and long‑term risks, may be more volatile.

Our analysis suggests we could see periods of bear steepening, where long-term yields rise faster than short-term yields. In such episodes, long‑dated government bonds would likely underperform shorter‑dated ones.

Overall, we’re watching out for more turbulent government bond markets, with periodic market stress as investors challenge governments that borrow too freely.

Parting is such sweet sorrow: the search for lower correlation

The greatest stars of the stage have a strong supporting cast to tread the boards beside them. This brings me to the second – and most crucial – factor behind our cautious stance on fixed income assets such as bonds.

In our view, the core role of high-quality bonds is to provide ballast when equities face their periodic spells of underperformance. But diversification only works when different asset types do not move in tandem.

Since the early 2000s, government bonds have typically been reliable diversifiers, often moving differently from equities. Recent years have broken that pattern. The most striking example is 2022, when investors faced double‑digit losses in both equities and government bonds simultaneously.

This is also evident in the market response to escalations in the Middle East; as government bonds have provided limited diversification benefits. 

We still believe that during periods of economic recession, government bonds could play a vital role in cushioning investment performance

However, not all market shocks are economic in nature, as the past few days have demonstrated. Today’s geopolitical uncertainty and shifting policy frameworks warrant a broader set of defensive tools: we must ensure that our customers’ investments can hold their own against a range of surprises.

I would argue that we need not rely on bonds alone to achieve this. Instead, multi-asset investors can utilise a wider suite of diversifiers to increase portfolio convexity and lower correlation to equity market risks.

Infinite variety: the world of alternative assets

Traditional diversification is under pressure, but the good news is that the investible universe is growing. The range of available alternative assets – investments that fall outside the traditional categories such as equities and bonds – has increased dramatically in recent decades.

Alternative assets encompass a wide range of asset types, from hedge fund strategies to commodities. Despite being a very diverse universe, alternatives often share common features such as lower correlation with equities and government bonds, and comparatively lower sensitivity to economic growth and inflation. 

These features can make alternative assets attractive over time, but they also create unique challenges when assessing their value within an investment portfolio. Due to the absence of clear and consistent relationships between alternative assets and economic variables, it’s no mean feat to generate expected returns in the same way we do for equities or bonds.

Instead, we rely more on historical analysis, focusing on the ability of alternative assets to provide diversification over time and protection during market selloffs.

Because alternatives display unique characteristics and behaviours, we often look to combine multiple alternative assets together in a basket with clearly identifiable features. One of these baskets, which we currently see as attractive for a subset of the portfolios that we manage, is comprised of so-called ‘liquid alternatives’. 

These strategies use a wide range of techniques, including (but not limited to) event-driven strategies – which takes positions in companies undergoing significant corporate events—such as mergers, acquisitions, bankruptcies, or spin-offs— focusing on predicting the outcome and timing of these events rather than relying solely on long-term fundamental analysis.

In keeping with signals from our Anchor and Cycle investment process, we have held our positive view on liquid alternatives within our more defensive mandates for nearly two years. Their outperformance versus government bonds is welcome, but their real value is their low correlation to both equities and government bonds.

All that glisters: the complexity and convexity of gold

This same thinking led us to reintroduce gold into some of our portfolios in January – not because of its recent popularity or price momentum, but because of its long‑standing role as crisis protection and its low correlation with mainstream asset classes. The market volatility following events in the Middle East has reinforced that decision. As markets opened on Monday 2 March, gold’s price jumped sharply, highlighting its value as both a diversifier and a traditional safe‑haven asset.

Gold is also associated with attractive ‘convexity’ qualities – its value typically rises when interest rates fall.

Gold’s low correlation to equity prices doesn’t mean that the gold price never falls when equity markets underperform. But broadly speaking, extreme falls in equity markets are gold’s time to shine. 

Escalations in the Middle East quickly led to volatility in financial markets. Equity and government bond prices fell on Monday 2 March, but we saw a spate of both rises and falls in the following days as investors attempted to price the uncertainties. The price of gold rose as investors sought defensive assets. Oil prices climbed, driven upwards by concerns about potential supply disruptions.

Backed by our Anchor and Cycle investment process, our eye is always on the bigger picture. We do not allow the gravity of geopolitical events to distort our investment judgement; instead, we focus on factors like economic growth and the outlook for corporate earnings.

From this perspective, the area that most deserves our attention is oil. Spikes in the price of oil are common before periods of economic recession, which in turn lead to wider financial market selloffs. But while many economic recessions follow an oil spike, not all oil spikes are followed by recessions. 

Further, dynamics in the global economy have changed in recent decades. The 1973 oil crisis stands as a defining moment in energy market history. The Organization of the Petroleum Exporting Countries (OPEC) nations in the Middle East implemented an embargo against the US, following Western support for Israel during the Yom Kippur War. This precipitated a fourfold increase in oil prices.

The abrupt supply contraction created by the embargo triggered widespread energy rationing, fuel shortages, and a global recession, which ended the post-war economic expansion. Analysis highlights that this crisis was underpinned by two critical factors: OPEC's control of the global oil supply, producing over 55% at the time, and Western economies’ dependence on imported oil with limited alternatives.

A weakened monopoly

The diminished market power of OPEC is a central factor mitigating the risk of a 1973-style crisis recurring. From 2015 to 2024, the US shale revolution accounted for approximately 90% of the increase in global oil production, elevating US output by over eight million barrels per day, to exceed 20 million barrels produced daily. This surge helped reduced OPEC's share of global production to roughly 46%. The change may not sound drastic, but it dilutes the group’s ability to enforce cohesive production cuts or embargoes.

Competition and divergent priorities within OPEC itself have also eroded its power, making coordinated supply alterations less probable. Saudi Arabia and the United Arab Emirates maintain significant spare capacity, estimated at 2-3 million and 4.5 million barrels per day respectively. This serves as a buffer against potential supply shocks.

The critical vulnerability remains the Strait of Hormuz, a maritime chokepoint near Iran through which approximately 20 million barrels per day transit, constituting nearly 20% of global oil consumption. However, the availability of over one billion barrels in IEA emergency stockpiles and the absence of a synchronised embargo reduce the likelihood of a protracted supply crisis akin to 1973.

Lower reliance from a net exporter

The alternatives to OPEC oil have also changed in recent decades. Most notably, the US is now relatively self-sufficient and has transitioned into a net energy exporter. As a global swing producer, the US can leverage its shale capacity to counter increases or decreases in global oil supply. This inherently lowers the probability of frequent extreme price spikes.

Empirical studies also estimate that US oil intensity – the volume of oil consumed per unit of GDP – has declined by roughly 70% since 1980, driven by advances in energy efficiency and a deindustrialisation trend. The former includes increased utilisation of natural gas and renewables, while the latter encompasses structural shifts toward less energy-intensive sectors such as services and technology. 

Little surprise, then, that the US economy and stock market now exhibit markedly lower sensitivity to oil price fluctuations.

Therefore, despite heightened geopolitical risks, we think that the probability and potential impact of a sustained 1973-style oil shock are substantially diminished in today’s diversified and adaptive global energy landscape.

Against this backdrop, we maintain our focus on the fundamentals. The US labour market – critical to the health of the US economy – remains in rude health. Jobless claims are close to their lowest levels this century, and data from the US manufacturing and services sectors (the Purchasing Managers Index, or PMI) signals economic expansion.

With this in mind, we maintain our focus on our core investment views, which I will recap below. 

Interest rate cuts are expected in 2026, but we are cautious about the extent of rate reductions Our proprietary analysis also indicates that the economy is entering an expansion phase, which traditionally supports stronger equity returns over bonds. We therefore expect equities to outperform bonds.

Aiming to bolster diversification within investment portfolios, we have – in certain portfolios – enhanced our allocation to alternative assets through gold and liquid alternatives. Gold can act as a ‘safe haven’ during geopolitical tensions, inflation, and policy surprises, and has been further supported by central bank purchases and a broad investor base. Liquid alternatives provide flexible strategies to limit losses, although they are suitable only for certain investors.

Meanwhile, emerging market (EM) equities present growing opportunities, benefiting from global expansion and robust technology sectors in countries such as South Korea and Taiwan. EM valuations remain attractive relative to the US, with promising earnings growth, particularly in semiconductor exports linked to AI developments. A weaker US dollar, although not central to our outlook, could further bolster EM equity performance.

In a nutshell: We favour equities over bonds, value enhanced diversification through gold and liquid alternatives, and hold an overweight position in emerging market equities to capture growth potential in 2026.

As part of the regular updates from my team, relevant to your investment service, you’ll receive a monthly letter like this from me to ensure you understand our investment views.

Until then, I wish you a steady and rewarding investment journey on the ever-changing market stage.

Yours sincerely,

Fahad Kamal

Chief Investment Officer