- Central banks led by the US Federal Reserve now are in inflation-fighting mode.
- Prospects of markedly higher interest rates suggest that the traditional 60/40 equity-bond portfolio needs rethinking.
- Balanced portfolios with diversification across all liquid asset classes and currencies still work well.
- Investors should embrace actively managed strategies that exploit higher rates and pricing inefficiencies.
With consumer price increases nearing double-digit percentages and the war in Ukraine moving elevated energy prices even higher, it’s now clear to everyone that inflation is anything but transitory.
Central banks led by the US Federal Reserve now are in inflation-fighting mode. It’s unclear what the economic cost of their about-turn will be. Some investors facing prospects of markedly higher interest rates, and losses on their bonds, are asking themselves whether this may be the end of the 60/40 portfolio.
An allocation of 60% to equities and 40% to fixed income (or the other way round in some countries) used to be the bedrock of investing. For generations of investors, such a portfolio combined the perks of equities – the possibility of capital appreciation – and the solidity of bonds including loss protection as well as solid yields.
Looking ahead, it seems clear that even with rate hikes, real yields (the nominal yield minus inflation) will remain negative in many segments of the fixed income universe. Moreover, the prospect of central banks unwinding trillions in debt on their balance sheets, thus selling the government bonds they hold, is hardly an enticement to buy such securities either. Meanwhile, equities can cushion portfolios against inflation, but with aggressive rate hikes looming, the prospect of higher prices has dwindled.
A hearty “jein” to a fresh look at portfolios
Does the definition of a balanced portfolio need a fundamental rethinking? In German, my answer for you would be “jein,” which roughly translates to “yes but no”. The year 2022 has taught us so far that balanced portfolios with diversification across all liquid asset classes and currencies actually work well for investors. While bonds and equities sold off in tandem at the start of the year, commodities and gold held their own. Investors with proper risk diversification will have been shielded from the worst of this year’s downturn.
Despite the scant protection and the negative real returns of government bonds, constructing a balanced portfolio without them would be unthinkable. Still, fixed income investors will want to pause for thought. We believe that owners of balanced portfolios should embrace actively managed strategies that exploit higher rates and pricing inefficiencies in segments ranging from low-risk, investment-grade bonds to high-yield corporate paper as well as emerging-market debt.
Keep in mind that inflation is the friend of an indebted government, as it reduces the cost of servicing existing debt. It is also a stealth tax on your cash, as its purchasing power is steadily declining. In this context, fixed income can provide an answer with asset-backed security strategies that can deliver attractive income along with a focus on capital preservation.
So while the future may not be as simple as a 60/40 mix between equities and government debt, the basic principle of diversification is more relevant than ever. Balanced portfolios need to be finely tuned, carefully calibrating return potential, capital preservation qualities, as well as risks, across all asset classes. The upshot, from our point of view: don’t give up on fixed income, just rethink your fixed income.