For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
A camp with a view
Since inflation re-emerged post 2020, we have been repeatedly saying that the standard 60/40 construction model is dead. Recent market movements have highlighted this, but many remain with the view that the conditions we have seen for the last 20 years will return.
Throwing the book at it
60/40 is shorthand for a portfolio that holds long dated bonds (40%) as a hedge for its equities (60%). The idea being that the bonds will go up when equities fall. Negative correlation worked for a couple of decades up to 2020 as low inflation drove strongly positive returns on bonds. In this period equity sell offs occurred because of weak growth and deflation, allowing for further falls in rates. This is by no means the normal scenario and certainly isn’t the conditions we are faced with today.
Any passing glance at an investment textbook suggest that the price of all long-term assets should be based off the risk-free rate, usually considered to be a US treasury bond. It follows that all assets should be positively correlated at least in the long term.
Indeed, that has been the case in the long term. Again, that investment text book might suggest that the price of the long term bond should reflect the opportunity cost of locking up money with the government in the long run. This is supposed to reflect long term economic growth. Growth is comprised of two things, real growth and inflation. It follows that as inflation expectations fall or GDP growth expectations fall bonds might rise.
Equity and bond correlations
Source: Bloomberg, data from 30.09.1975 to 30.06.2023.
A reversion to normality
At the moment we care seeing a painful sell off in the bond market driving equities off their recent highs. This is arguably being driven by inflation expectations rising amid higher oil prices and ever-increasing deficit spending in the US.
The reversion to normality has been painful in the near term, especially for those who hold too much duration in their bond portfolios. It need not be such a difficult scenario in the long term. Higher rates of inflation, as long as hyperinflation is not on the cards, are actually better for economic growth in the longer term.
Inflation oils the wheels of the economy. The transition may be painful as bond and equity prices readjust but the long-term outlook may actually be better. At least for real assets such as equities, property and commodities. In a higher inflation scenario, revenue can rise even if real output is declining. For the right companies, those with real assets and those that can pass inflation effects on, this environment is superior.
Old school thinking
The difficulty is most fund managers remain anchored on the old portfolio construction, even if they accept the higher for longer scenario. They believe bonds will be the hedge against equity falls. In fact, the opposite may be true, falling bond prices will be the cause of equity falls.
We think better hedges may be commodities, gold and potentially the dollar as higher rates drive money into the US as a safe haven.
We also think we should be guiding to higher nominal rates of return from portfolios in the long term, given the higher nominal growth rates and yields, at least for those portfolios not having excessive levels of duration.