It is a curious time for the US economy. The federal government is running its biggest deficits since World War II. Economic growth is set to exceed 5%. For the first time in a decade, inflation has breached 4%. Parts of the labour market look exceptionally tight. Stockmarkets are at record highs. And the Federal Reserve’s last action on interest rates was to cut.
The year is 1968, and though they didn’t know it at the time, US investors in the classic mix of 60% equities and 40% bonds were about to experience the worst period of negative real returns in history.
The culprit was inflation. Rather than stopping politely at 4%, it kept rising through the 1970s, ultimately eclipsing 14% in the US and well over 20% in the UK. The effects on the 60/40 were savage. Having grown accustomed to real returns of 4-8% per year, investors began losing 2-4% of their buying power every year. From the end of 1968 to the end of 1981, investors in the UK 60/40 lost a fifth of their purchasing power, and their American peers lost more than a third. Treasury bonds with double-digit yields were derided as “certificates of confiscation”, while Businessweek ran its famous cover, “The Death of Equities: how inflation is killing the stockmarket.”
Perceptions change. More recently, a 2019 Businessweek cover depicted inflation as a deflated dinosaur, with the headline asking “Is Inflation Dead?”
While a return of 1970s-style price spirals looks unlikely, inflation is still a risk worth worrying about. For a start, the parallels with the conditions of 1968 are eerie—indeed, every single point in the opening paragraph is as true today as it was then, suggesting a greater chance of at least moderate inflation. And even moderate inflation could seriously harm the strategy that has become the foundation of so many investors’ portfolios.
Cracks in the foundation
To understand the threats to the 60/40, it’s worth looking at how inflation affects bonds, equities, and the relationship between the two.
For bonds, the effect is straightforward. Inflation is the bond killer. Bonds pay fixed cash flows, so if inflation rises, those fixed payments buy less stuff in the future. Today, UK and US government bond yields are lower than expected inflation, so buy-and-hold investors will lose about 1% of their purchasing power every year for the next decade. That slow bleed is just the beginning of the potential pain. If investors start to worry more about inflation, they will demand compensation for it in the form of higher bond yields. When yields rise, prices fall, and today, a 1% increase in 10-year Gilt yields would knock prices by 9%.
The relationship between equities and inflation is more complex. On the valuation side, equities tend to draw the richest prices when inflation is low but positive—exactly the conditions of the past few decades. On the fundamental side, the effects vary between and within industries. If inflation rises because of high petrol prices, for example, oil producers might generate great profits. In other industries, some businesses have excellent pricing power, and can protect their margins by pushing through any cost increases to their customers. But in aggregate, the picture is mixed. You can pass on some costs sometimes, but you can’t pass all the costs on all the time. If cost inflation picks up, companies could find their margins squeezed.
So if rising inflation can hurt bonds and stocks individually, how does it affect the relationship between the two? Here, more bad news. In conventional booms and busts, stocks and bonds counterbalance each other, because growth and inflation pull in the same direction. But in a stagflationary environment, where inflation runs ahead of growth, both stocks and bonds could suffer, exposing the 60/40 to volatility and potentially poor returns.
A stronger foundation
Rather than leaning on a strategy best suited to the past few decades, investors should consider what will work from today’s starting point. With bond yields low, equity valuations high, and inflation risks rising, the classic 60/40 seems unlikely to repeat its past success. In fact, any static allocation seems unlikely to perform that well.
Instead, investors should consider something more active. Aggregate equity valuations are somewhere between full and frightening, but there are attractive pockets of value within stockmarkets – fast-growing technology businesses like TSMC in Asia, high-yielding value stocks like Mitsubishi in Japan, and strong but neglected companies like Comcast in the US. Targeting those opportunities while hedging the overall market risk provides a low-risk alternative to bonds. Other low-risk assets, like gold and inflation-linked bonds, can play a supporting role while offering some protection against inflation.
That protection looks more necessary than it has been in a long time. For the past 30 years, the 60/40 has been as solid as a castle. Today it looks like a castle made of sand.
Rob Perrone is a member of the multi-asset team at Orbis Investments. The views expressed above are his own and should not be taken as investment advice.