‘Why Not 100% Stocks?’

For what seems like a very, very long time, Wall Street analysts, strategists of various sorts and market participants in general have pondered the demise of balanced portfolios and particularly classic 60/40 allocation splits.

The thesis is straightforward. There’s only so low bond yields can go, so the capacity of bonds to cushion an equity drawdown has become more limited over time.

Additionally, many worry that the combination of modern market structure and distortions created by massive central bank asset purchases, have made government bond markets more fragile and prone to so-called “fragility events” (e.g., tantrums).

The upshot is that not only are bonds constrained in their capacity to offset weakness in equities, they could actually become a source of considerable risk and portfolio volatility.

“The edifice of portfolio construction leans on the negative correlation between the risk-free and risky asset,” Macro Risk Advisors’ Dean Curnutt wrote last month, noting that although the setup has worked well for more than two decades, it’s not a given.

“What happens when the stabilizing impact of duration as a risk class turns the other way?”, Curnutt went on to ask. “A flip in stock/bond correlation would likely come about at the same time as both stock and bond volatility were both increasing. The portfolio vol greatly expands.”

Arguably, the post-pandemic environment has raised the risk of diversification desperation materially. Indeed, Wednesday was a good example. Equities sold off and bonds did too, as the hottest US CPI print in 30 years conspired with a lackluster 30-year auction to play havoc.

Equity duration is near record highs, which means US shares are extremely vulnerable to a rapid rise in rates. According to BofA’s math, a 1ppt increase in the cost of equity would push the S&P sharply lower, to around ~3,600.

It’s also important to remember that it’s not necessarily the level of yields that matters, but the rapidity of rate rise. In a separate note dated Wednesday, BofA looked at historical instances of a 50bps increase in US 10-year yields over relatively compressed timeframes. The results were about what you’d expect.

One-month spikes of 50bps or more in US 10-year yields have happened 38 times since early 1962 and they typically coincide with weaker average returns, median returns and a lower percentage of time up for the index, BofA said. “The month of the yield spike shows the SPX up only 39% of the time on an average return of -1.20% (-1.46% median),” Stephen Suttmeier wrote.

In the second installment of a three-part series on the outlook for balanced portfolios post-COVID, Goldman’s Christian Mueller-Glissmann, Cecilia Mariotti and Peter Oppenheimer wrote that although the global shift to fiscal-monetary partnerships post-pandemic helped economies recover and markets rebound more quickly than they otherwise might, the “changing policy mix… will have long-lasting implications for both 60/40 returns and portfolio risk.”

The narrative is familiar. Both bonds and stocks are stretched, and given the current low level of yields, “the buffer from bonds for equity drawdowns in the event of growth shocks is smaller,” Mueller-Glissmann said, cautioning that equities “might also struggle to digest higher bond yields.”

Note that estimated duration for a standard 60/40 portfolio is now near record highs going back more than a century (figure below, from Goldman).

“S&P 500 equity duration has increased due to valuation expansion and a larger weight for US secular growth stocks,” Goldman wrote, noting that “lower real yields since the GFC and the COVID-19 crisis have boosted valuations of secular growth stocks [and] and as a result, US 60/40 portfolios are more risky – higher equity duration increases exposure to stagnation and inflation tails, while higher bond duration mainly increases risk from inflation.”

This is a problem if macro volatility persists beyond the near- to medium-term. With each passing above-consensus inflation print, those of a bearish persuasion (a camp which has quite a bit of overlap with central bank critics) become more convinced that the “Great Moderation” is over.

If inflation becomes unanchored or even exhibits a tendency to be less predictable than it’s been for the past several decades, central banks may be less inclined to persist in ultra-accommodative policy in an effort to smooth out any and all turbulence. As Mueller-Glissmann put it, “anchored inflation… allowed central banks to err on the side of caution and buffer the business cycle more proactively.”

Needless to say, an increase in macro volatility could play havoc with balanced portfolios, particularly if inflation becomes less predictable and policy rates rise, imperiling stretched valuations.

Considering all of the above and the fact that equities can serve as an inflation hedge, you’d be forgiven for asking why investors shouldn’t just abandon 60/40 altogether in favor of 100/0. “With bond yields near all-time lows it is appropriate to ask again, why not 100% equities?”, Goldman wrote.

Don’t laugh. Because Goldman isn’t. And this is hardly the first time someone has asked the question. (I’m loath to cite Cliff since he spitefully banned me from viewing his social media accounts — either because I politely suggested that comparing Progressive policy proposals to Venezuela was a stretch that intelligent people generally don’t attempt, or else because my ocean view is better than his — but in the context of this discussion, I’d be remiss not to link to this piece.)

Needless to say, Mueller-Glissmann and his colleagues went into considerable detail, but for our purposes, just note that Goldman reiterated everything said here at the outset.

“The value of bond allocations, from both a return and risk perspective, is more questionable at the zero lower bound and with potential for higher inflation,” Goldman said, adding that “equity/bond correlations might be less negative, bond returns are likely to be lower versus both equities and cash, and rates volatility might be higher in the new cycle.”