Wall Street likes to warn that past performance does not guarantee future results, but when it comes to the traditional 60/40 mix of stocks and bonds, it kind of has. Persistent inflation could bring that to an end.
The strategies, in which portfolios hold 60% stocks and 40% bonds, have produced just two down years since 2007. During the pandemic, they have been beating averages dating back to the 1980s. The asset allocation mix posted a 17% return in 2020 and is on course for another double-digit return this year. But it posted losses in September and November and is down 0.4% so far in December, just as the Federal Reserve (Fed) started signalling a hawkish shift.
For decades, investors — particularly retirees — have ploughed trillions into this mix because it offers growth with a layer of safety. The idea is stocks are the engine, while high-quality government bonds are insurance during market angst. Both asset classes are very liquid and transparent in terms of pricing, providing investors with the core building blocks of a long-term portfolio. Finding an alternative has also proved challenging. For all the talk about the potential demise of the strategy, assets such as private equity, real estate and private markets are far less liquid and less readily available to retail investors saving for retirement.
However, a number of fund managers think 60/40’s stellar run is coming to a close — and the reason is inflation. “You can’t look at something that has worked well for the past 30 years and expect it will continue,” says Jean Boivin, head of BlackRock Investment Institute, which forecasts an annualised total return of 5.6% from a global 60/40 portfolio over the next decade.
The first issue is US equities and Treasuries are already expensive by a number of measures. So the bar for additional gains is high. Second, the high-quality bonds that are favoured on the fixed-income side of the strategy get hit hardest when inflation pushes yields higher. Benchmark 10-year Treasury yields are currently around 1.4%, up from as low as 0.31% last year. The Bloomberg Treasury Index has lost 1.4% this year on a total return basis through Dec. 3, according to a Bloomberg index.
“In this environment, we think 60/40 is pretty dangerous,” says Sandi Bragar, managing director at Aspiriant, who oversees US$13 billion ($17 billion) of investments.
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Pain point
Bond-market measures of inflation expectations over the next fiveand 10-year periods have hit their highest since inflation-linked debt was introduced in the US in 1997. The five-year so-called break even inflation rate has jumped to around 2.8% from 1.8% a year ago. And that is down from 3.2% in mid-November. Investors got a sense of what the pain point could look like in September, when inflation flared and stocks and bonds simultaneously fell, which is a rarity. A Bloomberg 60/40 index slid 3.2%, the largest monthly decline since the onset of pandemic lockdowns in February last year. This scenario is now becoming more common. In just the last week, there have been several days when large-cap stocks and government bonds have posted losses, showing the recent warnings about the risks of 60/40 strategies could have merit.
Bubbling inflation has sparked traders to price in two rate hikes next year from the Fed. That would make it difficult for bonds to fulfil their role as a defensive hedge. With fixed-coupon payments not even beating inflation, investors may keep demanding higher yields — risking a broad financial shock that spills into equities.
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“There has been a 30-year period where bonds have played a very good defensive role in portfolios,” says David Giroux, portfolio manager at T. Rowe Price, who has run the US$54 billion Capital Appreciation Fund since 2006. “Today, we are in a world where yields are below the inflation rate, so you are not getting compensated in real terms for buying investment-grade and Treasury bonds.”
Rejiggering the mix of equities in portfolios is also key for investors, given the high valuations of US large-cap stocks, according to Meb Faber, chief investment officer at Cambria Investments. “Going global is better, and that also includes owning real assets through REITs, commodities and managed futures,” he says. Faber sees 60/40 returns in the low single digits over the next decade. Vanguard, meanwhile, recently updated its forecast for 60/40 returns to a median annualised gain of 3.8% through 2031.
Stocks win
Ultimately, it is the fear of negative total returns that has so many asset managers looking for alternatives to high-quality bonds in their portfolios. T. Rowe’s Giroux, for example, says that shares of utilities are better positioned than Treasuries to act as ballast. “They are growing their earnings at 6% and pay a 3% dividend yield, so you have a 9% total return,” he says.
Another approach is owning leveraged loans, as they pay a floating rate of interest and have less volatility than equities. BlackRock’s Boivin says his firm suggests putting about a quarter of a multi-asset portfolio in global government bonds and tilt toward higher-yielding sovereign debt, like that from China.
In addition, there’s a shift toward high yield and away from lower-yielding sovereign bonds has gained favour. And the booming demand for alternative assets such as private markets and real estate by pension funds reflects anxiety that low returns from a classic mix of equities and bonds will suffer in the coming decade, particularly if inflation remains elevated.
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Still, many investment managers have decided to simply chase the high returns from stocks while winnowing their exposure to bonds. Some investors have boosted their allocations to an 80/20 model, seeking in particular exposure to companies that can pass on higher prices to customers in an elevated inflationary climate. Global stocks that trade at lower valuations than their US peers are also getting a longer look.
“The hurdle rate to make bonds attractive versus equities is so low that equities are still the preferred investment,” says Margie Patel, senior portfolio manager at Allspring Global Investments, which manages US$587 billion in assets. “No matter how I do the math, over any reasonable time period you are going to make more in equities.”
This skew holds even in an environment where rates remain historically low with inflation pressures subsiding, as investors believe that tapping equity dividends from quality companies is better than seeking returns from plain vanilla bonds. “One thing we’ve seen some of our clients in the 60/40 do is move that to being more of like 60, 10, 30 with the 10% in dividend equities,” says Steve Chiavarone, portfolio manager at Federated Hermes, which manages US$634 billion. “Right now the best thing to do in 60/40 is to overweight equities. Equities are a better inflation hedge.” — Bloomberg
Cover photo: Frederick Warren/Unsplash
