Earlier this week, in “Why Not 100% Stocks?“, I revisited the debate around the viability of 60/40 portfolios in an era where macro volatility is expected be higher, driven by heightened inflation uncertainty (figure below).
For now (and this assumption seemingly becomes more tenuous by the week), most market participants believe that even if inflation proves to be something other than “transitory,” the odds of a 70s-style spiral are low, as are the chances of long-end bond yields becoming totally unanchored.
That latter bit is key. As discussed briefly in the linked article (above) and at some length on innumerable occasions over the past several years, the amount of embedded duration across assets is substantial. A disorderly rise in yields is akin to lighting a fuse.
The crucial takeaway from any discussion about 60/40 viability in an environment of increased macro volatility is that bonds could fail the cushion equity drawdowns or, worse, could become a source of considerable risk and portfolio volatility.
In the context of 60/40 portfolios, bond volatility has generally been “good” because, as Goldman wrote this week, rates vol “has mostly been driven by deflationary growth shocks” in recent years.
Growth scares typically aren’t digested well by equities, but falling yields in anticipation of disinflation or outright deflation help offset declines in stocks. “Since the 1990s, equities have been much more volatile than bonds as growth has been the main risk, while inflation has been anchored,” Goldman’s Christian Mueller-Glissmann remarked.
That raises an obvious question: What happens if inflation, instead of growth, is the main risk?
Note that the market-based probability of CPI being above 3% over five years is now over 60% while the probability of inflation running below 1% is basically zero (figure above).
Over the last two decades (a period defined by the “have your cake and eat it too” dynamic engendered by the combination of negative stock-bond correlations but simultaneous, multi-year rallies in both assets), the risk contribution from bonds in a 60/40 portfolio has collapsed, while the contribution from stocks rose above 100% (figure on the left, below, from Goldman).
“In recent years, rates volatility has mostly been driven by deflationary growth shocks – thus bond volatility was ‘good’,” Mueller-Glissmann wrote, on the way to cautioning that “rising inflation might drive more ‘bad’ bond volatility.”
Additionally (and this is an extension of the notion that bonds have limited capacity to cushion equity drawdowns given how low yields already are), Goldman wrote that “at the zero lower bound ‘good’ bond volatility is likely to be limited.”
In the same lengthy note, Goldman wrote that there are different ways to capture relative risk — volatility isn’t the only measure. As the figure on the right (above) illustrates, tail risk was almost exclusively confined to stocks over the course of the “Great Moderation.” But that needn’t necessarily be the case.
“Before the 1990s, US 10-year bonds actually had higher tail risk than equities due to more inflation/rate shocks,” Mueller-Glissmann observed. “While in the last cycle the balance of risks was clearly in favor of bonds, the same cannot be said for the post-pandemic cycle.”
Two final thoughts. Because long duration equities command such a massive share of market cap, benchmarks are unusually vulnerable to duration “events” (for lack of a better euphemism). In some types of multi-asset portfolios, the bond portion is highly levered, in part due to assumptions about bonds being the less volatile asset.
If not 60/40, then what? REITs, physical real estate, commodities, precious metals? Crypto (for the believers)?
I’d personally go with physical RE but it requires so much up front capital it’s not open to “normal” people like us (I assume). You can only buy a couple of apartments or houses, you can’t buy an office building, a retail center or an industrial asset, let alone a diversified portfolio of such.
REITs would be a nice solution but because they’re way more liquid than their underlying, they tend to move with the broader equity market, thus cancelling the diversification benefits.
Allocating to PE and VC funds is also a good strategy but, again, require a fair bit of cash, especially if you want to keep committing in order to avoid being overly concentrated in a single vintage…
So – yeah, easier said than done if you don’t happen to have a few handfuls of millions at minimum…
The Economist says more cash.
https://www.economist.com/finance-and-economics/2021/11/13/cash-is-a-low-yielding-asset-but-has-other-virtues
https://www.barrons.com/articles/how-to-protect-your-portfolio-from-the-inflation-storm-51636733972?st=qkfqsglcgmpkspi says short duration corporate bond closed end funds
There are a lot of different amounts cited on the internet for the size of the US bond market, the US equity market, the global bond market and finally, the global equity market- so I am not exactly sure, but the bond market is obviously larger than the equity markets.
Even if investors are currently enjoying a rate of return on their previously purchased long term bonds that is in excess of current and anticipated inflation; what happens when that bond matures- and they have to redeploy that capital? Hard to imagine they would redeploy into bonds earning such a low rate of return, but I really do not know.
If 60/40 becomes 65/35 or 70/30 in this environment where rates are either so low or you have to be much, much riskier (i.e. junk bonds) to get a decent return (causing investors to be more amenable to shifting more capital to equities); then stocks might become even more expensive as capital shifts from bonds to stocks. Even with a small shift, trillions could move out of bonds and into equities.
My portfolio is 30/60/10 (stks/FI/cash) My bet for your question is that the odds of future rates going up is higher than he odds for a decline. Therefore, reinvestments of semi-annual coupons, fund distributions and principal payments will be into instruments with at higher rates. I have 50 CEFs (40% in munis) and 25 individual corp, muni, and UST bonds. All are priced above par and offer significant unrealized gains. Like most fixed income investors, I’m always happy no matter what happens. If rates go down, capital gains are there if you want them. I spent nearly 20 years building my portfolio from capital gains collected on discount UST bonds bought on the margin. When rates are rising, then my returns get better every day. Hold the old buy the new like crazy. Seriously, do you want to be holding Tesla and tech stocks when reality bites? Where’s the real floor. Musk wants the cash.