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Is more trouble coming for the 60/40 portfolio?

The traditional 60/40 equity/bond portfolio has performed poorly during the recent period of high and persistent inflation. With some indication that peak inflation has passed, now seems a good time to do a stock-take on the year so far and what it might imply for portfolios going forward.

It seems to me that the easiest way to parse where markets sit is by way of analogies to three famous children’s stories: The Boy Who Cried Wolf, Goldilocks, and The Pied Piper of Hamelin.

The ‘Goldilocks’ tale’s application to financial markets is well-known; laboured even. The others, however, are less well-known but now perhaps highly apposite.

Despite a stubborn failure for the data to conform, the bond markets have had a tendency since the commencement of the Federal Reserve (Fed) tightening cycle to ‘cry wolf’ regarding recession. The flipside has been a tendency to over-estimate the rapidity with which inflation might decline and the extent of Fed tightening.

That reflected the ongoing effects from what was (with the benefit of hindsight) an excessive fiscal and monetary response during the pandemic and its aftermath. It also may reflect a lack of appreciation that the current monetary policy tightening cycle was from a base of a historically high level of global monetary accommodation. It was also borne of a complacency about the type of inflation inertia that level of monetary accommodation wrought, along with supply shocks encouraged by the pandemic and war and exacerbated by deglobalisation and reregulation.

However, it pays to remember that the famous parable of The Boy Who Cried Wolf concludes with the wolf finally showing up, but only after the townsfolk have been lulled by fatigue into a complacency borne of the unnecessary panic induced after the boy’s false alarms.

Are financial markets too complacent?

Is there a parallel with the market’s current circumstance? Financial markets, perhaps fatigued by unfulfilled prognostications of recession, have grown a little complacent?

If so, the portfolio implications (at least tactically) are clear: a focus on defensive portfolio attributes are primary.

Does that include traditional nominal government bonds as a core component of the ‘40’ in 60/40?

My own view is that it should, at least in the US. Inflation in the US has meaningfully turned: the 3-month annualised core consumer price index (CPI) was 5.0% in May, down from a peak of 7.1% in June 2022, while 3-month annualised Cleveland Fed trimmed-mean measure fell to 3.2% in May, down from a peak of 7.8% in July 2022, and the lowest level since March 2021.

However, inflation does look ‘sticky’ and might remain so.

There are also global structural currents that make elevated developed-country inflation rates more ‘sticky’. The globalisation of labour supply (after the fall of the Berlin Wall and the ‘export’ of labour from large emerging market economies such as China and India) is abating; globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of ‘industrial policy’ and ‘national champions’; domestic regulation of markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).

While US 10-year and 2-year bonds at yields around 3.80% and 4.70% respectively imply that nominal bonds can regain some of their defensive characteristics, other defensive instruments such as inflation-linked bonds, low risk market-neutral (or ‘unconstrained’ / ‘absolute return’) bond funds or even gold and other commodities (as an inflation hedge) or defensive equity portfolios are useful ways to enhance the defensive characteristics of a portfolio.

For domestic investors there is a further rider. Inflation appears to have passed a meaningful turning point in the US. However, locally, questions remain.

The recent decision by the Fair Work Commission (FWC) will increase price pressures and increase pressure on the Reserve Bank of Australia (RBA) for further policy rate increases. Such wage increases are digestible in times of reasonable productivity growth, but the recent national accounts showed productivity growth at an abject -4.5% over the past year, and unit labour cost growth (the most relevant labour cost gauge for inflation) is at a whopping 7.9% – and this was before the FWC decision.

So, while inflation in the US may have passed a meaningful turning point, Australia faces a more serious challenge, and the RBA may have a fair bit more ‘wood to chop’ and local bond yields some upside. Locally, on a ‘duration neutral’ basis, defensive portfolios are best skewed toward inflation-linked bonds and other defensive assets rather than nominal bonds.

   

Arguably a combination of an RBA that was late out of the gates on inflation and who then prevaricated on its commitment to inflation containment, combined with wage-setting arrangements inimical to inflation containment, has increased the chances of a deeper dislocation in employment and activity in Australia than elsewhere as the RBA struggles to get ahead of the inflation curve.

In this sense Australia has yet to pay the (inflation) piper.

Where does this leave portfolios?

In the US, the traditional 60/40 equity/bond portfolio might make something of a comeback, although with the inclusion of return sources uncorrelated with equities or bonds. Perhaps something like a 50/30/20 portfolio with the ‘20’ being assets uncorrelated with equity or bond returns (e.g., long/short or ‘market neutral’ bond and equity portfolios or macro hedge funds) offers better diversification. And even with nominal bonds as the core defensive asset, other defensive assets such as inflation-linked bonds might appeal.

In this way, should the recession wolf show up, villagers (investors) can protect the livestock (portfolios) with nominal bonds and other defensive (mostly inflation-hedge) assets.

For Australian investors, given the tasks facing the RBA and the potentially ‘stickier’ inflation outlook, the calculus is not so clear. The appropriate portfolio mix might look more like 45/25/30, with the ‘30’ being assets uncorrelated with equity or bond returns. Moreover, given the idiosyncratic (upside) inflation risks in Australia, it may pay to have a reasonable proportion of the ‘45/25’ component in foreign (mostly US) equity and bonds.

Of course, this survey would not be complete without a contemplation of the ‘Goldilocks’ narrative. Can the Fed successfully engineer a relatively benign disinflation (so-called ‘immaculate disinflation’) without an excessive dislocation in activity and employment (it looks less likely for the RBA)?

That rarely happens, but…

 

Stephen Miller is an Investment Strategist with GSFM, a sponsor of Firstlinks. He has previously worked in The Treasury and in the office of the then Treasurer, Paul Keating, from 1983-88. The views expressed are his own and do not consider the circumstances of any investor.

For more papers and articles from GSFM and partners, click here.

 

4 Comments
Steve Dodds
July 20, 2023

I'm somewhat bemused by those proclaiming the death of 60/40.

The rise of 60/40 was based on evidence of its suitability for those with a long-term investment horizon but without the stomach for the volatility of 100% equity.

Yes, it performed badly in FY2022. But so did most things.

But (using the Vanguard Growth Fund as a proxy) it is up 10% in FY2023, about even over 2 years, up 6% over 5 years, and up 10% over 20 years.

An investment in 100% equities would have performed better (as of now) but it would have underperformed for 14 years (based on 2004 inception).

To dump a strategy that has performed as advertised for decades based on one bad year seems like the antithesis of sensible advice. To suggest it after the strategy has had the bad year seems even less sensible as there is abundant evidence that asset classes that underperform one year tend to outperform the next year.

If this article had appeared in November 2021 it might have been useful for those with a short-term outlook and a punters mentality, but the horse has bolted.

Diversifying into long/short, market neutral, macro hedge, private equity etc may be a good thing, but there is very little long-term evidence that such investments are as defensive as the author suggests. Let alone the difficulty of accessing them.

Regal, for example, is one of the most popular market neutral managers. Their listed fund is down 20% in the last two years.

And the advice to have 30% of your Australian portfolio in investments uncorrelated to equities and bonds seems sensible, but doesn't actually say what these investments are.

Private equity, for example, is also hard to access and has a limited track record. The Pengana listed PE fund is certainly not correlated to 60/40. It is down 10% over the past six months.

Infrastructure held up over two years but was about equal over five.

60/40 may be boring. But for most people it still makes sense.

Disclaimer: I myself don't use 60/40. I'm OK with the volatility of all equity

Jason
July 05, 2023

Basically the deep debtors and asset owners in Australia want deeper negative real interest rates. Creditors and those relying entirely on their wage and without assets other than a cash reserve are wanting realistic interest rates.

The first group are complaining too much as interest rates aren't really much above the neutral rate in Australia and are still deeply negative real.

The second group are hoping for inflation to subside.



Jeff P
June 30, 2023

Economics amuses me because so much of it is an imperfect science. There is still significant disagreement about what caused the latest inflation. In fact, economists don't agree what causes inflation full stop.

Then there's interest rates. Now, there are more economists questioning if interest rates really work to bring down inflation. If interest rates near zero didn't lift inflation for most of the 2010s then why should higher interest rates dampen inflation?

I think we've got to accept this imperfection and recognise that economies are extraordinarily complex and human beings are far from rational.

From there, any economic forecasts should be treated as tentative or directional, at best.

Economist
July 07, 2023

Jeff P, nice attempt at caricature there, but every economist does know what causes inflation. They will all tell you that it's when overall demand in the economy exceeds overall supply so that prices across a range of markets go up, sufficient for that to show up in broad measures like the CPI. There may be some disagreement about what causes demand to exceed supply in particular situations, and the relative contributions of short term displacements in key markets like energy, but that it's excess demand one way or another is beyond dispute. Also every economist knows that higher interest rates will bring inflation down. The dispute is whether there are other policies that could contribute as well and whether the trade-off between the slowdown in economic activity that higher interest rates produce and the lower inflation is the right balance. That economic forecasting is an imprecise activity is also beyond dispute and should be treated, as you say, with caution. Again, I don't know too many economists - well there are a couple like someone with a joyous sounding surname - who wouldn't admit the imprecision of their own predictions.

 

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