David Jane
Premier Miton Macro Thematic Multi Asset Team
Last year we wrote a series of notes regarding the highly prevalent belief in the 60/40 model of portfolio construction, our view on its inappropriateness going forward and alternative approaches that might be more successful. Given that 6 months have nearly passed since that series, we thought it would be worth considering how things are playing out.
Our view is that in an environment where inflation has become a more important issue going forward, bonds would not only perform poorly, but become positively correlated with equities. This is clearly playing out as expected. The chart below shows the long-term correlation between S&P 500 Index and US Treasuries, with the green section showing positive correlation and the red section showing negative correlation. The two most important asset classes are now positively correlated.
Correlation between S&P 500 Index and US Treasuries – 1975-2022
Source: Bloomberg, 31.01.1975 – 25.04.2022.
Inflation continues to surprise to the upside and the correlation of bonds and equities is becoming hard to ignore. Inflation looks set to remain a dominant issue going forward, given policy response on both the fiscal and monetary sides are still hardly disinflationary, and the supply chain issues remain intractable. Our basic hypothesis looks to have been correct, what about our suggestions?
In bonds, we highlighted our belief in the positives of short-dated bonds versus longer dated ones and that one could seek returns from credit spreads rather than duration. This has worked reasonably well, although gains have been hard to come by. Longer dated government bonds have been particularly poor and are also becoming correlated to equity.
In equity, we suggested the dominant growth themes of the past decade would face a strong headwind as rates rose, impacting their valuations and the market would switch to preferring value type equities. This has certainly been the case. Our materials, agricultural and energy equities have done well over recent months, although financials have been less good. Obviously, the Ukraine situation has given these areas a further boost of late, but the hypothesis has certainly been right. Asset based businesses have done much better than growth.
Our final suggestion was to look again at some other potential diversifiers of portfolios, notably gold and other commodities such as base metals, agricultural commodities and REITS, as well as other asset backed structures. These have provided some of the biggest winners in our portfolios over recent months, particularly as both equities and bonds have trended lower. Exchange Traded Commodities have provided inflation protection, without the margin and volume worries of the miners and fertiliser stocks.
We think the underlying longer term environment will remain inflationary for some time, making for an ongoing headwind for those strategies based on the old normal. The downtrends in bonds may occasionally reverse, but in the long term, have the potential to be one of higher yields. Barring occasional bear market rallies, a mainstream approach to bonds will often be loss making in real terms in our opinion. Over time, we believe that more and more investors will come to realise that the old consensus approach is a thing of the past.
