In our society's latest attempt to get something for nothing, we're Opening Pandora's Box.
Some things in life are so ubiquitous, pervasive and enduring that their existence and consequences are not only taken for granted, but nearly invisible. So it is with the four-decade trends of benign inflation, falling interest rates and rising stock prices. These trends are thoroughly baked into the assumptions underlying most portfolio construction methodologies. The ubiquitous “60/40” equity/bond portfolio, and all of its permutations, epitomizes this.
Over these past decades, conditions have been highly supportive of both bond and stock prices. Low inflation and falling interest rates make existing debt issued with higher coupons appreciate in value. For companies, low borrowing costs and steady economic growth led to increasing earnings. With yields on bonds so low, investors were happy to pay more for stocks, especially those that could offer what appeared to be sustainable growth. Consequently, both of principal components of the traditional blended portfolio have dramatically outperformed actuaries’ expectations.
But as Herb Stein famously said, if something cannot go on forever… it will eventually stop. This remarkable period of market history has left us with highly expensive stock markets AND highly expensive bonds – particularly here in the US. Against this we perceive an unravelling of most (if not all) of the forces that propelled assets to these heights. Central banks are hell-bent on pushing inflation higher, utilizing all conventional tools at their disposal and introducing new ones as they go along. Hello electro-dollars! Legislatures around the world are embarking on round after round of fiscal stimulus. And corporate earnings have fallen well behind the growth in equity values over the past several years.
In a word, this all is starting to smell a lot like stagflation.
If stagflation is the order of the day, where does that leave the US-centric 60/40 portfolio? Quite possibly, dead in the water. The implications for the multitude of investors that rely on this basic template are enormous. Paladin’s solution is to look through and beyond these core asset classes in order to identify which portions within US markets are worth holding onto, and which markets outside the common blended equity/bond portfolio offer better returns.
While the US stock market as a whole is entirely over-bought, this is not true of all sectors and all stocks. Excluding large cap tech stocks represents an immediate improvement. Similarly, steering the equity portion of the portfolio towards international and emerging market stocks results in better expected returns. There is perhaps less latitude to reposition in bonds, but “real assets” like commodities and real estate offer a valuable hedge against higher inflation, and some desperately needed diversification.
Calling time on a 40-year regime of falling inflation and rates—not to mention accelerating corporate earnings—isn’t for the faint of heart. Given the magnitude and duration of these trends, being even slightly early can translate into years of waiting. Rather than going all in on a stagflationary outlook, we’re transitioning portfolios to be more robust to both deflationary and inflationary scenarios. We expect the transition from the former to the latter will be bumpy and afford many profitable opportunities to reposition along the way.
It will be interesting to see whether the broad community of asset managers adopts a similar approach and attempts to find something more appropriate than that old faithful. Unfortunately, in this industry, as in many others, the old adage “it is better to fail conventionally than succeed unconventionally” holds sway. What’s for sure is that as investors cast about for solutions, we’ll start to see some increased dispersion in performance. There will be winners and losers, rather than winners and winners.
For more views and insight, see our 3Q 2020 letter, Opening Pandora's Box.