What Is Structural Diversification in Financial Portfolios

Structural diversification relates to the fact that different types of financial assets react in different but predictable ways to each of the different economic regimes. The behavior of these assets in response to economic regimes is structural because of the inherent price discovery mechanism that is embedded in each asset.

For example, interest rates respond predictably to inflation. When inflation is expected to decline, the Central Bank will lower interest rates, which causes bond prices to rise.
When inflation is rising in response to monetary policy actions, gold, real estate and commodity prices will hold their value relative to a weakening currency. As a result, the Central Banks will raise interest rates and thus bond prices will decline.

Developed market stock market equity prices react to declining inflation expectations. Low inflation also means lower industrial and labor input costs, which fatten up profit margins.

On the other end of the spectrum, during periods of surging global growth that are accompanied by rising inflation expectations, emerging market stocks will tend to dominate. This has much to do with the fact that many emerging economies supply the commodities that are consumed by developed nations during a global boom, while commodity prices are rising on the back of strong demand and rising inflation expectations.

Lastly, during periods like the Great Depression, there are negative GDP prints coupled with price deflation so that cash preserves its value relative to other goods and assets, while low and declining interest rates boost long-duration Treasury bond prices. Historically, gold has served a role in this regime as authorities roll out the printing presses in their quest to conquer the prevailing deflationary forces.