The sky is falling…or is it?

Lots of recent headlines have been focusing on the past/present and the future of the traditional 60% equity/40% bond portfolio – ‘R.I.P. the 60/40 portfolio’, ‘Long live the 60/40 portfolio’ and ‘Time to rethink the 60/40 portfolio’ have popped up in the trade press.

Whilst investors have been trained to regard the 60/40 portfolio commonly introduced some 70 years back as a set-it-and-forget-it benchmark, a low interest rate environment and a structurally higher inflationary regime might mean advisers have to consider getting more creative.

Shaping the past decade were expanding stock valuations, boosted by the relentless interest rate lowering cycle and abundance of liquidity. As equities rose, so did bonds, with the traditional 60/40 construct delivering attractive returns for client portfolios. Easy money lifted all boats.

Following the Covid-19 pandemic, and as central banks have finally shifted their narratives away from inflation being more transitory in nature, and toward it being more entrenched (and thus recognising the need to tackle the problem before it gets worse or gets out of hand akin to the runaway inflation of 1970s), the current aggressive tightening cycle pursued by those banks has created a whole new environment, creating challenging times for asset prices. Suddenly, the correlation construct between bonds and equities has broken down: both fell in unison as the year unfolded.

Following a stellar run over recent years, it’s been an annus horribilis for global bonds. Showing their worst performance in decades, global bonds entered their first bear market in a generation, declining by more than 20% from their January 2021 peak (USD / unhedged terms). Admittedly, as the US Fed continued to step up its rate hiking cycle, the dollar rally softened the blow for GBP investors in global fixed-income assets. Closer to home, what of the performance of core UK gilts year to date? A similar picture – core UK gilts are down in excess of 20% over the period amidst rising bond yields. UK inflation-linked bonds? Worse still, as inflation protection elements got overwhelmed by duration exposure. This saw portfolios with greater allocation to bonds (including the long-dated stuff) – those portfolios labelled lower-risk and therefore expected to insulate in times of market dislocations – fare particularly badly as they fell broadly in line or more compared to higher risk models.

Looking back though, it is not unusual for correlations across bonds and equities to spike higher during market selloffs. The 60/40 portfolio has lost money before, but investors patient enough to hold tight were typically rewarded through a subsequent recovery phase. This time, however, the dynamic is different – whilst interest rates have come quite some way from the pandemic lows, inflation shows little signs of abating. It appears more structurally entrenched, underpinned by supply/demand imbalances and rampant geopolitical tensions aggravating the strain around the already unlikely return of global supply chains the way we knew them. The rise of the bargaining power of labour and higher energy prices will likely continue being present in the medium term, fuelling persistence of inflationary pressures. Not least, as China continues to rebalance its policy, we are unlikely to see inflation being suppressed over the medium term.

Having been criticised for falling behind the curve, and with their credibility at risk, central banks are finally at it – the rate hiking cycle is gathering velocity. The potent combination of higher inflation and still low nominal rates in the context of runaway prices calls for a more aggressive tightening. And so what? More is yet to come. It is entirely possible markets might get worse before they get better.

Determined to bring prices down, even if it upsets the growth balance in doing so, the risk of central bankers delivering a policy error remains material. A broad-based darkening of the global growth outlook, however, spells challenges for central bankers’ ability to raise rates significantly beyond the level of neutral (although neutral readings might reset higher), accounting for structurally higher inflation. Winding forward to 2023, we might start seeing value emerge in long-dated bonds if rates were to top out and to start falling in response to falling global growth. Whilst bonds may not have fully repriced yet, when they do, bond prices will become attractive again, offering higher yields and scope to deliver positive performance as well as equity diversification.

Until then and more broadly, the challenge around the conventional 60/40 portfolio is finding a liquid enough and a large enough pool of assets to substitute for longer bonds as rates continue rising. As investors increasingly recognise that fixed-income assets will unlikely be able to deliver performance akin to the prior few decades, portfolio allocation to alternatives (including real assets, commodities, and absolute return vehicles) may continue to gain ground. Alternative assets’ ability to offer an element of diversification also holds appeal. Real assets within alternatives, including property and infrastructure, boast attractive levels of income whilst having an embedded inflation protection – an attractive characteristic in the currently high inflationary environment and a likely structurally higher inflationary regime in the medium term.

Commodities (including precious metals) may benefit from rising global geopolitical tensions. Since the worst days of the pandemic caused by Covid-19, most commodity prices have been recovering, benefitting client portfolios. Scarcity of natural resources, underinvestment in the energy sector in recent years, and the growing conflict in Ukraine together led to a recent material rally in commodities. Undoubtedly, a global recession may see a pull-back in commodity prices. Whilst industrial metals may be more susceptible (showing some weakness already), weather and climate risks, ongoing geopolitical tensions and lower sensitivity in demand could see food and energy process remain elevated. Performance of gold is worth a mention. Whilst a lot of the ingredients that should have driven the price of gold higher came through in the last few years, returns have been somewhat underwhelming. Instead, gold has behaved as a currency against the dollar, in a way. As the dollar continued to strengthen, the price of gold moved in the opposite direction. Having said that, as the prospects of stagnant growth and structurally higher inflation are increasing at the time when geopolitical tensions show no signs of abating, the environment for gold prices to move higher may be approaching.

Absolute return and hedge fund strategies within alternatives are set to benefit from choppier markets amidst increased uncertainty and heightened volatility both through 2022 and beyond. As markets contend with an inflationary and rising rates environment, we are likely to continue to witness greater dispersion in performance across regional markets, sectors, factors, and individual securities. Market regime changes and plentiful alpha generation opportunities make hedge funds and absolute return vehicles look relatively attractive. Differences in returns across managers is noteworthy, however. It pays to be selective.

Beyond the more traditional liquid alternative assets, product development around illiquid strategies, including private equity, private real estate, private credit and digital currencies has been gathering pace. These are more sophisticated, complex and often more expensive vehicles. We’ll leave this for another time.

Another way to enhance the traditional 60/40 portfolio approach is to employ more targeted exposures within traditional asset classes – targeted beta, including short duration, factor, sector, country exposures etc. Currency hedging could be seen as another performance lever, although is more difficult to get consistently right over time. Does this spell the end of the more traditional broad index investing? Not necessarily. Proliferation of both broad index instruments as well as a wide array of funds allowing greater precision offers a spectrum of tools to achieve desired client outcomes. We have been employing this approach in client portfolios with meaningful results. It goes without saying that being diversified across styles of investing (both value and growth) and the market cap (large, mid and small) offers benefits over the long run.

On balance, the traditional 60/40 portfolio provides a useful framework, although it probably needs to evolve, considering the environment we are currently in, whilst looking ahead. An element of modernisation of the traditional model is required. Equities are expected to remain a core return engine in years to come, a function of prolonged life expectancy and structurally lower interest rates given prevailing global debt levels. The level of returns for bonds is likely to be lower, whilst the level of risk assumed to deliver the same return is expected to be higher as interest rates will probably remain at historically-relatively-low levels considering global debt prognosis. Based on recent changes in capital markets, a greater exposure to alternative sources of return (funded from core fixed income) offers a palatable solution for portfolios through offering an attractive level of returns, inflation capture, yield generation in some cases, as well as a level of diversification to both equities and bonds. Embracing alternatives as a core component of multi-asset portfolios may help in delivering attractive balanced risk-adjusted returns over time.

To finish off, I must stress that whilst investors often have polarising views around asset allocation and portfolio construction, most seasoned astute operators tend to agree on one thing – time in the market is more important than timing the market. On balance, markets tend to go up over the long run and market volatility does tend to be relatively short lived. Several market studies considering the longer-term time horizon show material underperformance of portfolios missing out on just a dozen of the best trading days when compared to those staying the course through market’s ups and downs. Miss out on more that the best ten days and the results get exponentially worse.

Stay invested, stay diversified.

And until next time, stay well.