What, if anything, comes after 60/40?
A year ago, with core inflation (excluding food and energy) at a mere 4 per cent, we showed you this chart from UBS, comparing rolling 36-month core inflation against 36-month stock/bond correlations:
When core inflation rises above 2.5 per cent and stays there, stock and bond returns correlate. When that happens, the core premise of the 60/40 portfolio — when your stocks falter, your bonds will rise — looks shaky. And so it has turned out. With 36-month core inflation now at 3.1 per cent, the 60/40 portfolio has done historically badly.
This is old news. But it comes at an interesting moment. There is a plausible case that inflation will eventually moderate — and another plausible case that inflation is now structurally higher. If the latter proves true, the 60/40 portfolio can no longer be the default — what you might call the “dumb portfolio” for people who hate thinking about investing, but want to get it broadly right (we mean “dumb” as a compliment here).
If we have entered an era of higher inflation, what comes after 60/40? It’s a huge question.
The standard suggestion is to add in “alts”: something besides stocks, bonds or cash, with performance uncorrelated to one or the other. Commodities are an obvious candidate. They look good as a diversifier, jumping during times of stress, but are less appealing for capital appreciation. Even after the recent commodity surge, the broad trend since the 1970s has been sideways:
There’s also real estate, which we can separate into home ownership and real estate investment trusts. Outside of severe recessions, house prices have only gone up, though at a snail’s pace compared to stocks:
The caveat here is that this is a price comparison. It ignores the rental yield from real estate, if you don’t live in it. Then again, you never call the plumber to fix your stock portfolio, either.
Reits — or rather some Reits — can act as an inflation hedge. Leases that reset annually, as is common for multifamily units, let rents rise with prices. Mark Hackett at Nationwide’s Investment Management Group tells us he likes Reits’ combination of reasonably low volatility and yield generation. One difficulty, though, lies in how diverse Reits are. You have to look at the underlying assets and structure.
Then there is private markets. Even if these were easy for average investors to access — they are not, except indirectly through large pension funds — their procyclicality and high fees cut against their inclusion in the dumb portfolio. Returns from private capital were strong 10 years ago. Now they are crashing to earth. And, as we have argued here several times, just because they are not marked to market does not mean they are truly uncorrelated to public markets.
There are more exotic alts like art or infrastructure available. Write in if you think we’ve missed an important option. It is a high bar to be both accessible to a wide investor base and offer exposure not already captured by stocks and bonds. There isn’t some “well, duh” alternative waiting in the wings. (Wu & Armstrong)