60/40 resilience in an inflation age

The fiscal and monetary authorities of the developed world are engaged in a great macroeconomic experiment. Governments are spending enormous sums to combat the recessionary effects of the pandemic and central banks are allowing monetary policy to stay loose in order to accommodate the fiscal stimulus. Eventually, inflation and inflation expectations are bound to rise.

Here is what that means for investor portfolios. I recently highlighted a relationship from a Credit Suisse chart indicating that 50/50 balanced fund drawdowns rise during periods when stock-bond correlations are high (see Are you positioned for the post Great Rotation era?). Stock-bond correlations tend to rise during periods of rising inflation expectations. Balanced funds composed of simple stock and bond allocations will therefore experience greater volatility and higher drawdowns. Simply put, fixed-income holdings don't perform well in such environment which lessen their diversification effects against stocks and damage the resilience of balanced fund portfolio to unexpected shocks.

Bloomberg reported that sovereign wealth funds are becoming anxious about the 60/40 portfolio model.

Two of the world’s largest sovereign wealth funds say investors should expect much lower returns going forward in part because the typical balanced portfolio of 60/40 stocks and bonds no longer works as well in the current rate environment.

Singapore’s GIC Pte and Australia’s Future Fund said global investors have relied on the bond market to simultaneously juice returns for decades, while adding a buffer to their portfolio against equity market risks. Those days are gone with yields largely rising.

“Bonds have been in retrospect this gift,” with a 40-year rally that has boosted all portfolios, said Sue Brake, chief investment officer of Australia’s A$218.3 billion ($168.4 billion) fund. “But that’s over,” she added, saying “replacing it is impossible -- I don’t think there’s any one asset class that could replace it.”

Thanks to declining returns from bonds, the model 60/40 portfolio may eke out real returns -- after inflation -- of just 1%-2% a year over the next decade, said Lim Chow Kiat, chief executive officer of GIC. That compares with gains of 6%-8% over the past 30 to 40 years, he said.

Norway, whose SWF is the largest in the world at $1.3 trillion in assets, had already shifted to a 70/30 target asset mix.

Norway’s $1.3 trillion sovereign wealth fund has already made the shift, winning approval to adjust its equity-bond mix to 70/30 in 2017. At the end of last year, it held about 73% in equities, and 25% in bonds.

Inflation expectations will rise in the next market cycle. The only debate is over timing. How can balanced fund investors build resilient portfolios to control risk and enhance returns during such periods?

I have some answers.

The full post can be found here.