The macroeconomic backdrop is evolving. Structural forces – from geopolitical tension and deglobalisation, to demographic change and climate transition – are contributing to an uncertain world in which inflation is likely to be more persistent and, crucially, more volatile. This matters because it influences how assets behave. 

As central banks respond more forcefully to inflation risks, both equities and bonds can become more sensitive to the same macro drivers. Bond yields may rise as investors demand greater compensation for inflation, while equities can come under pressure as higher input costs and tighter financial conditions weigh on valuations and margins. The result is that, at times, both asset classes can move in tandem.

If this proves to be a defining feature of the foreseeable investment landscape, it raises a fundamental question: how should portfolios be constructed when traditional diversification is less dependable? 

The answer is not to abandon equities or bonds, but to recognise that diversification needs to be broader and more deliberate. Relying solely on their historical relationship may no longer be sufficient in achieving consistent outcomes across a range of economic scenarios. It is within this context that private markets are becoming increasingly relevant.

The illiquidity risk premium has been less evident in recent years. Public markets have largely absorbed the impact of the 2022 interest rate shock, but private markets have undergone a more prolonged adjustment. As a result, expected excess returns over public markets have moderated – particularly in longer-duration investments such as private equity. This has prompted renewed scrutiny of some core assumptions: whether the illiquidity premium has structurally compressed, and whether private market returns are as diversifying as widely believed.

The starting point today is meaningfully different from that of recent years. Real interest rates have adjusted significantly and are now closer to long-term equilibrium estimates. While rate expectations are currently shifting upward alongside rising inflation expectations, a dramatic reappraisal of the kind that defined 2022 is unlikely to be repeated unless we see a renewed surge in inflation.

Whilst this points to a more stable regime, the conditions that supported negative correlations between equities and bonds are unlikely to return to pre-pandemic levels. Portfolio volatility may therefore remain structurally higher, reinforcing the need to diversify beyond traditional asset classes.

In this new environment, the underlying attributes of private markets can play a more consistent role. Assets with inflation-linked revenues, floating-rate income streams or exposure to structural growth trends may help to mitigate some of the pressures that challenge traditional portfolios. At the same time, their return drivers are often less synchronised with public market movements.

Forward-looking return expectations for private investments should nevertheless be more measured. The tailwinds that supported private market performance over the previous decade – notably ultra-low interest rates and widespread use of leverage – are less evident today. Future outcomes are likely to depend more on underlying asset quality, disciplined deployment of capital and active value creation.

The importance of selectivity is therefore key – and places greater emphasis on quality of implementation. Dispersion of returns across private markets has always been wide, and that dispersion is likely to persist. As such, capturing the benefits of these asset classes requires a considered and well-resourced approach – including access to high-quality opportunities and strong manager capability.

Equally important is how private market exposures are integrated within the broader portfolio. They should complement public assets, adding diversification where it is most needed, rather than acting as a simple substitute.

In April 2026, Sarah Breeden – Deputy Governor for Financial Stability at the Bank of England – named private markets as one of three systemic vulnerabilities confronting the UK financial system. She pointed to the sector’s rapid growth (global AUM has risen roughly six-fold since 2008, to around $18 trillion) and warned that it has yet to be tested at that scale by a broad-based macroeconomic shock in a higher-rate environment.

Her specific concerns are worth understanding clearly. She highlighted limited transparency and valuations that may lag reality; weakened underwriting standards; leverage that operates at multiple layers – borrower, fund and sponsor – making it difficult to measure in aggregate; and complex interconnections with banks, insurers and reinsurers that make losses hard to trace when stress emerges. 

These are legitimate concerns. They reinforce the importance of disciplined implementation and the need to avoid opacity, poor underwriting and undifferentiated exposure. A well-resourced investor with genuine depth of research capability, long-established manager relationships and rigorous selectivity can heed Breeden’s warning.

Our approach is built around the qualities she implicitly calls for: transparency at the asset level, conservative use of leverage, close attention to valuation discipline, and a granular understanding of how each private allocation connects to the broader portfolio. The concerns raised at the systemic level reinforce rather than undermine our conviction – they are a reminder of why quality of implementation matters so much, and why our scale and experience offers a genuine advantage. 

For PruFund, the core investment objective remains unchanged: to deliver smoothed, long-term growth through deeply diversified portfolios. What is evolving is the way diversification is achieved. In an environment where inflation risk is more pronounced and traditional correlations are less reliable, a broader and more flexible portfolio construction approach is required. Private markets continue to play an important role within this framework, providing exposure across private credit, private equity, real estate and infrastructure.

By maintaining diversification not only across asset classes but within them – and by leveraging the scale and expertise of the wider investment platform – the portfolio is positioned to navigate a wider range of potential outcomes.

The implications are clear. In a more inflation-aware world, diversification cannot rely solely on the interaction between equities and bonds. Instead, it must be built across a wider set of return drivers – incorporating assets that respond differently to inflation, growth and policy dynamics.

In our view, inflation is likely to remain a more prominent and persistent risk. This raises important questions about the roles different asset classes play within portfolios. Although private markets have undergone adjustment in recent years, much of the compression in excess returns has been driven by the shift in the interest rate regime. If this dynamic stabilises, as we expect, their inflation-mitigating characteristics should become more evident. As such, private markets remain a key component of our asset allocation – and one in which we have high conviction.  

Private markets are by no means a panacea. But used selectively and in the right context, they can play a meaningful role in strengthening portfolio resilience as the investment landscape continues to evolve.

This content has been prepared by the Life Investment Office (LIO) for information purposes only and does not contain or constitute investment advice.