Investors have been relying on the 60-40 portfolio strategy for decades to ensure steady growth and income. But slowing economic growth, rising inflation, and high market volatility, primarily caused by the ongoing Russia-Ukraine war, are changing drastically the investment playbook. The portfolio construction of the period after the 2008 financial crisis, characterized by low inflation and low volatility, seems not to work anymore. Starting from an overview of portfolio investing over time and a brief summary of recent geopolitical and market events, this article seeks to analyze the elements that are changing and the ones that will stay the same, tracing the changes to causes.
Overview of portfolio investing over time
At the beginning of the last century, investing consisted of a form of gambling for wealthy people, who were betting on stocks that they thought were at their best price, which was calculated with the Dividend Discount Model, introduced by John Burr Williams in the book The Theory of Investment Value. The value of a stock should equal the current value of its future dividends. At that time, information was really slow, and technology really poor. In this context, economists were trying to make some important progress. For instance, Benjamin Graham was focusing on getting precise and accurate information and on analyzing this information properly, in order to use it for making investment decisions. In 1949, Graham published The Intelligent Investors, “By far the best book on investing ever written” according to Warren Buffet. Due to this book and Security Analysis(1934), two of the founding texts of neoclassical investing, Graham is considered the father of value investing, an investment approach that Graham started teaching at Columbia Business School. Value investing is based on the idea that the market overreacts to changes in price in the short run, taking too little into consideration company’s fundamentals for long-term growth. Value investing is based on the fundamentals of a company, on the calculation of the intrinsic value of this company. Therefore, it will focus on undervalued stocks of firms that have the potential and capabilities to perform in the long term, but also on real estate, bonds, and other assets traded at a lower price than their intrinsic value. An essential aspect of this approach is patience, the investor must wait until assets can be purchased at prices that are lower than their real value, and until the undervalued asset just bought can be sold at a higher price. In The Intelligent Investor, Graham focuses also on the so-called group approach. Investors should buy groups of stocks that meet the basic criterion of undervaluation, regardless of the industry, and with little care for the individual company.
In contrast to value investing, growth investing is an investment strategy focused on capital appreciation. Practically speaking, it consists in investing in companies that are growing at an above-average growth rate, even if the share price looks expensive in terms of metrics such as price-to-earnings. Thomas Rowe Price is considered the father of growth investing because of his work promoting and defining this strategy through his company T. Rowe Price, investment firm founded in 1937.
However, until then no one was focusing on risk, the only concern was finding undervalued stocks that guaranteed higher returns. This happened until a 25-year-old student from Chicago changed the financial world. Harry Markowitz, reading John Burr Williams' book was not satisfied by the absence of consideration of the risk of a particular investment. In 1952 he wrote the article “Portfolio Selection”, published in the Journal of Finance, concluding that risk, and not the best price of assets, should be the main point of any portfolio. Once the risk tolerance of investors is identified, the portfolio is built by plugging investment into a mathematical formula. Markowitz formalized the trade-off between returns and risk. There are assets with high returns and high risk, such as stocks, and assets with low yields and low risk, such as sovereign bonds. He created a way to match the risk tolerance of the investor and reward expectations, creating an ideal portfolio. The Modern Portfolio Theory allowed investors to demand portfolios that fit their risk-reward profile. In 1990, Markowitz won the Nobel Prize for his pioneering contributions in the field of financial economics, and for decades, Modern Portfolio Theory has shaped the way investors, financial advisers, and institutions have invested all over the world.
This theory led to the birth of the 60/40 portfolio strategy. 60% equity, 40% bonds. Even if bonds don’t guarantee high returns, they can be used as volatility dampeners. Their value can clearly be understood by looking at recessions. Typically, during recessions, central banks lower interest rates to stimulate the demand for investments and stimulate growth. As we all know, an interest rate decrease will make the price of the bonds go up, counterbalancing the fall of the shares’ value. Therefore, a portfolio with a balanced level of bonds and stocks, allows you to obtain this counterbalance which is very important during recessions. For decades, by combining these two asset classes in the 60/40 split, investors were able to receive almost the same returns they can receive if just investing in shares, but with much lower volatility.
However, the 60/40 strategy has largely benefitted from the 40 years’ decline in interest rates, which led to an increase in the value of bonds, that boosted the returns of the 60/40 portfolio. Nowadays, the real interest rates are largely negative, and this has eroded the benefits of holding 40% of bonds. Something is therefore changing.
Recent events and market updates
The last decade was characterized by anchored inflation and pretty good economic growth, but bad enough for central banks to ease monetary policy, because they were worried about deflation and secular stagnation.
Instead, the economy is nowadays dominated by slow economic growth, rising inflation, and high volatility, mainly caused by the Russian-Ukraine war. The annual inflation rate in the US accelerated to 8.5% in March 2022. In February it reached 7.9%, largely driven by supply bottlenecks and hiring difficulties, but also by rising energy, food, and services prices. In March it increased more due to the war that is driving up energy costs, reaching the highest rate since 1981. The gasoline index rose by 18.3% in March and accounted for more than half of all the items’ increases. But not only cyclical factors are affecting inflation, there are also structural factors such as deglobalization, decarbonization, and the fight against income inequality. Moreover, the US economy contracted by 1.4% in the first three months of 2022. The Cboe Volatility Index® (VIX) spiked from 28 to 37.5 after the announcement of the war, and it has strongly increased in the last months.
Fed monetary policy is characterized by high uncertainty. On one hand, the record level of inflation suggests a sharp increase in interest rates, on the other hand, Fed warned that a strong increase in interest rates could pose a risk to a fragile US economy and, in particular, to the financial system. “A sharp rise in interest rates could lead to higher volatility, stresses to market liquidity, and a large correction in prices of risky assets, potentially causing losses at a range of financial intermediaries”, reported the Fed in the financial stability report. This would also reduce the ability of financial intermediaries to raise capital and keep the confidence of counterparties. The Fed also issued a warning about liquidity, it stated that the ability to buy or sell assets at prices quoted by broker-dealers had “deteriorated”. In the meanwhile, Fed increased the interest rates by 25 basis points in March and by 50 basis points in May.
To sum up, interest rates have decreased for 40 years, but now there is no more space for more decrease, and this is deeply changing investment allocation.
Finally, if US stocks largely outperformed other countries’ stocks for many years mainly due to low and anchored inflation, falling real yields, and the incredibly high level of profit margins of the tech sector, the level of outperformance will probably decrease due to the change in the economic framework. At the beginning of the year, Europe outperformed the US market up until the beginning of the world. In addition, as we are moving toward a less globalized world, with segmentations in the good markets and capital markets, the correlation between markets is going down and, therefore, diversification benefits are becoming greater.
Moving forward
It is probable that a period like the previous one of anchored inflation, good economic growth and very good profit sector growth is unlikely to continue, as we expect we will have to deal with higher inflation, less favorable valuations across assets, less favorable profit margins and lower returns. This will lead to a markedly different environment for asset allocation compared to the immediate aftermath of the pandemic outbreak, or to the previous decade. Hence, how should our portfolio change to be able to maintain a return similar to the previous one?
Asset Allocation and the interaction with growth
Firstly, we must recognize that other than risk aversion and investment goals, asset allocation in portfolios depends on the interaction with growth.
If we have good growth, which, in times of inflation, means equities can beat it, then we want to own a bit more equity, a bit less fixed income, and 40 percent bonds, 60 percent equity portfolio works.
If growth lowers and risk of recession rises, that is what we presume for the next period then we have to lower the presence of cyclical stocks in our portfolio and consider:
Types of real assets to consider should be:
A new, more dynamic, structure
Expected low returns from a 60/40 portfolio call into question the efficacy of traditional approaches to asset allocation. In particular, the inability of fixed income to provide either compelling returns or diversification suggests that investors need a fresh approach to portfolio construction.
Some bankers, like Scott Ladner, CIO of Horizon Investments, are focusing on a change of the “standard” percentage, maintaining types of assets almost unchanged, assigning only the 20% to fixed income and the remaining 80% to equities, to minimize the amount of “dead money”.
Instead of a traditional “barbell” strategy built with high volatility equity and low volatility, negatively correlated bonds, other bankers, like Christian Mueller-Glissmann, asset strategist at GoldmanSachs, prefer to follow a “full spectrum” approach to uncover alternative sources of return. In this case, we consider evolving and dynamic percentages of different assets, so that there are some parts of the portfolio providing growth and returns, but also part of it being more defensive and trying to smooth possible downturns.
In the full spectrum approach, in fact, particularly suited for skilled and resourced individuals, investors can move into a range of nontraditional investment strategies (fixed income-focused, mid risk and equity-focused) and adjust their risk management to address higher levels of complexity and illiquidity.
Asset reposition and growth outlooks
In whatever case, a reposition of the portfolio is essential. In particular we should make sure equity, fixed income and commodities resist inflation's risk and volatility, focusing on its source, and try to find growth opportunities in them. In particular, we recognize main trends and drivers for inflation as:
Overview of portfolio investing over time
At the beginning of the last century, investing consisted of a form of gambling for wealthy people, who were betting on stocks that they thought were at their best price, which was calculated with the Dividend Discount Model, introduced by John Burr Williams in the book The Theory of Investment Value. The value of a stock should equal the current value of its future dividends. At that time, information was really slow, and technology really poor. In this context, economists were trying to make some important progress. For instance, Benjamin Graham was focusing on getting precise and accurate information and on analyzing this information properly, in order to use it for making investment decisions. In 1949, Graham published The Intelligent Investors, “By far the best book on investing ever written” according to Warren Buffet. Due to this book and Security Analysis(1934), two of the founding texts of neoclassical investing, Graham is considered the father of value investing, an investment approach that Graham started teaching at Columbia Business School. Value investing is based on the idea that the market overreacts to changes in price in the short run, taking too little into consideration company’s fundamentals for long-term growth. Value investing is based on the fundamentals of a company, on the calculation of the intrinsic value of this company. Therefore, it will focus on undervalued stocks of firms that have the potential and capabilities to perform in the long term, but also on real estate, bonds, and other assets traded at a lower price than their intrinsic value. An essential aspect of this approach is patience, the investor must wait until assets can be purchased at prices that are lower than their real value, and until the undervalued asset just bought can be sold at a higher price. In The Intelligent Investor, Graham focuses also on the so-called group approach. Investors should buy groups of stocks that meet the basic criterion of undervaluation, regardless of the industry, and with little care for the individual company.
In contrast to value investing, growth investing is an investment strategy focused on capital appreciation. Practically speaking, it consists in investing in companies that are growing at an above-average growth rate, even if the share price looks expensive in terms of metrics such as price-to-earnings. Thomas Rowe Price is considered the father of growth investing because of his work promoting and defining this strategy through his company T. Rowe Price, investment firm founded in 1937.
However, until then no one was focusing on risk, the only concern was finding undervalued stocks that guaranteed higher returns. This happened until a 25-year-old student from Chicago changed the financial world. Harry Markowitz, reading John Burr Williams' book was not satisfied by the absence of consideration of the risk of a particular investment. In 1952 he wrote the article “Portfolio Selection”, published in the Journal of Finance, concluding that risk, and not the best price of assets, should be the main point of any portfolio. Once the risk tolerance of investors is identified, the portfolio is built by plugging investment into a mathematical formula. Markowitz formalized the trade-off between returns and risk. There are assets with high returns and high risk, such as stocks, and assets with low yields and low risk, such as sovereign bonds. He created a way to match the risk tolerance of the investor and reward expectations, creating an ideal portfolio. The Modern Portfolio Theory allowed investors to demand portfolios that fit their risk-reward profile. In 1990, Markowitz won the Nobel Prize for his pioneering contributions in the field of financial economics, and for decades, Modern Portfolio Theory has shaped the way investors, financial advisers, and institutions have invested all over the world.
This theory led to the birth of the 60/40 portfolio strategy. 60% equity, 40% bonds. Even if bonds don’t guarantee high returns, they can be used as volatility dampeners. Their value can clearly be understood by looking at recessions. Typically, during recessions, central banks lower interest rates to stimulate the demand for investments and stimulate growth. As we all know, an interest rate decrease will make the price of the bonds go up, counterbalancing the fall of the shares’ value. Therefore, a portfolio with a balanced level of bonds and stocks, allows you to obtain this counterbalance which is very important during recessions. For decades, by combining these two asset classes in the 60/40 split, investors were able to receive almost the same returns they can receive if just investing in shares, but with much lower volatility.
However, the 60/40 strategy has largely benefitted from the 40 years’ decline in interest rates, which led to an increase in the value of bonds, that boosted the returns of the 60/40 portfolio. Nowadays, the real interest rates are largely negative, and this has eroded the benefits of holding 40% of bonds. Something is therefore changing.
Recent events and market updates
The last decade was characterized by anchored inflation and pretty good economic growth, but bad enough for central banks to ease monetary policy, because they were worried about deflation and secular stagnation.
Instead, the economy is nowadays dominated by slow economic growth, rising inflation, and high volatility, mainly caused by the Russian-Ukraine war. The annual inflation rate in the US accelerated to 8.5% in March 2022. In February it reached 7.9%, largely driven by supply bottlenecks and hiring difficulties, but also by rising energy, food, and services prices. In March it increased more due to the war that is driving up energy costs, reaching the highest rate since 1981. The gasoline index rose by 18.3% in March and accounted for more than half of all the items’ increases. But not only cyclical factors are affecting inflation, there are also structural factors such as deglobalization, decarbonization, and the fight against income inequality. Moreover, the US economy contracted by 1.4% in the first three months of 2022. The Cboe Volatility Index® (VIX) spiked from 28 to 37.5 after the announcement of the war, and it has strongly increased in the last months.
Fed monetary policy is characterized by high uncertainty. On one hand, the record level of inflation suggests a sharp increase in interest rates, on the other hand, Fed warned that a strong increase in interest rates could pose a risk to a fragile US economy and, in particular, to the financial system. “A sharp rise in interest rates could lead to higher volatility, stresses to market liquidity, and a large correction in prices of risky assets, potentially causing losses at a range of financial intermediaries”, reported the Fed in the financial stability report. This would also reduce the ability of financial intermediaries to raise capital and keep the confidence of counterparties. The Fed also issued a warning about liquidity, it stated that the ability to buy or sell assets at prices quoted by broker-dealers had “deteriorated”. In the meanwhile, Fed increased the interest rates by 25 basis points in March and by 50 basis points in May.
To sum up, interest rates have decreased for 40 years, but now there is no more space for more decrease, and this is deeply changing investment allocation.
Finally, if US stocks largely outperformed other countries’ stocks for many years mainly due to low and anchored inflation, falling real yields, and the incredibly high level of profit margins of the tech sector, the level of outperformance will probably decrease due to the change in the economic framework. At the beginning of the year, Europe outperformed the US market up until the beginning of the world. In addition, as we are moving toward a less globalized world, with segmentations in the good markets and capital markets, the correlation between markets is going down and, therefore, diversification benefits are becoming greater.
Moving forward
It is probable that a period like the previous one of anchored inflation, good economic growth and very good profit sector growth is unlikely to continue, as we expect we will have to deal with higher inflation, less favorable valuations across assets, less favorable profit margins and lower returns. This will lead to a markedly different environment for asset allocation compared to the immediate aftermath of the pandemic outbreak, or to the previous decade. Hence, how should our portfolio change to be able to maintain a return similar to the previous one?
Asset Allocation and the interaction with growth
Firstly, we must recognize that other than risk aversion and investment goals, asset allocation in portfolios depends on the interaction with growth.
If we have good growth, which, in times of inflation, means equities can beat it, then we want to own a bit more equity, a bit less fixed income, and 40 percent bonds, 60 percent equity portfolio works.
If growth lowers and risk of recession rises, that is what we presume for the next period then we have to lower the presence of cyclical stocks in our portfolio and consider:
- Absolute-return hedge fund, a type of investment that attempts to generate steady, positive returns in all markets environment by using investment strategies as derivatives, arbitrage, short selling and leverage;
- More defensive and real assets. They can in fact do well even if the growth backdrop isn’t that great (which is what is currently happening), since they retain real value or have some type of ability to generate real cash flow growth.
Types of real assets to consider should be:
- Commodities. Gold, in particular, can be quite interesting as well as a kind of long-term store of value, especially looking at debasement risk over the long run;
- Real estate.
- Infrastructure. Looking at broad infrastructure indices, they’ve been doing really well year to date. It has contractually defined inflation in most of the cases so yields on most of them are positive (in contraposition with index-linked bonds).
A new, more dynamic, structure
Expected low returns from a 60/40 portfolio call into question the efficacy of traditional approaches to asset allocation. In particular, the inability of fixed income to provide either compelling returns or diversification suggests that investors need a fresh approach to portfolio construction.
Some bankers, like Scott Ladner, CIO of Horizon Investments, are focusing on a change of the “standard” percentage, maintaining types of assets almost unchanged, assigning only the 20% to fixed income and the remaining 80% to equities, to minimize the amount of “dead money”.
Instead of a traditional “barbell” strategy built with high volatility equity and low volatility, negatively correlated bonds, other bankers, like Christian Mueller-Glissmann, asset strategist at GoldmanSachs, prefer to follow a “full spectrum” approach to uncover alternative sources of return. In this case, we consider evolving and dynamic percentages of different assets, so that there are some parts of the portfolio providing growth and returns, but also part of it being more defensive and trying to smooth possible downturns.
In the full spectrum approach, in fact, particularly suited for skilled and resourced individuals, investors can move into a range of nontraditional investment strategies (fixed income-focused, mid risk and equity-focused) and adjust their risk management to address higher levels of complexity and illiquidity.
Asset reposition and growth outlooks
In whatever case, a reposition of the portfolio is essential. In particular we should make sure equity, fixed income and commodities resist inflation's risk and volatility, focusing on its source, and try to find growth opportunities in them. In particular, we recognize main trends and drivers for inflation as:
Starting from fixed income, clearly, given the rise of inflation and the Fed much more aggressive interest rate policy, the bonds have not been a good hedge against equity selloffs. This asset class has been particularly hit in the last quarter, as the Bloomberg Global Aggregate Bond Index registered a maximum reduction of 6.2% YTD. So what include in the 40% (lower or higher) are Treasury Inflation-Protected Securities, more expensive bonds whose principal and interest rate payments rise along with inflation, low duration bonds and some other protection against risky assets, which may come from arbitrage strategies or from alternative strategies that basically, synthetically, create the risk.
Going to commodities, any of them, from agricultural to energetic, has to be taken into observation. Due to the recent Russia-Ukraine conflict, gas, coal, oil, precious metals and wheat have registered highs, especially in Europe, which is the most exposed region. These out performances have been sustained also by the general climate of inflation, the previous supply chain shortages caused by the last two years’ lockdowns and the new increasing attention to sustainability, which requires to look for new alternative resources to invest in.
Hence, we are getting into an environment where access to commodities will drive a lot of the growth and where, rather than thinking in terms of emerging markets versus developed markets, we will speak about commodity importers versus commodity exporters, looking at the particular makeup of those regions.
Concluding with equity, we can see that all economies at the moment are experiencing uncertainty in markets. Nevertheless, in the last cycle, the US economy and the US equity market, thanks to their high-liquidity, stable risk premium, low and anchored inflation, falling real yields and lower exposure to the Russia-Ukraine crisis, have offered incredibly attractive growth.
Geographic diversification has not been really considered then, however some of the key drivers of recent US large-cap and small-cap stocks outperformance (technological innovation and low interest rate) may not be as pronounced going forward, so we still look to broader geographical diversification.
Growth opportunities to take into observation are surely:
Talking about thematic diversification, instead, We should focus particularly on the following areas:
Conclusions
In conclusion, in a period of high inflation, uncertainty and new developing opportunities, the best asset strategy allocation seems to be the dynamic one, with which we can constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens.
Moreover, the change in the geopolitical landscape, the particular attention to existing commodities and to new renewable resources, and the acceleration of the 3Ds phenomena (Decentralization, Decarbonisation, Digitalization), will boost growth across different parts of the world towards many industries and at different peace, leading to difference in monetary and fiscal policies.
The dynamism brought about by these changes will remodel the economic outlook and present great opportunities for investors.
Sources
Going to commodities, any of them, from agricultural to energetic, has to be taken into observation. Due to the recent Russia-Ukraine conflict, gas, coal, oil, precious metals and wheat have registered highs, especially in Europe, which is the most exposed region. These out performances have been sustained also by the general climate of inflation, the previous supply chain shortages caused by the last two years’ lockdowns and the new increasing attention to sustainability, which requires to look for new alternative resources to invest in.
Hence, we are getting into an environment where access to commodities will drive a lot of the growth and where, rather than thinking in terms of emerging markets versus developed markets, we will speak about commodity importers versus commodity exporters, looking at the particular makeup of those regions.
Concluding with equity, we can see that all economies at the moment are experiencing uncertainty in markets. Nevertheless, in the last cycle, the US economy and the US equity market, thanks to their high-liquidity, stable risk premium, low and anchored inflation, falling real yields and lower exposure to the Russia-Ukraine crisis, have offered incredibly attractive growth.
Geographic diversification has not been really considered then, however some of the key drivers of recent US large-cap and small-cap stocks outperformance (technological innovation and low interest rate) may not be as pronounced going forward, so we still look to broader geographical diversification.
Growth opportunities to take into observation are surely:
- UK equities. They, particularly in the last cycle, have been a very interesting asset due to the sector exposure to energy, banks and healthcare. In addition, its value has high dividend yield and it's been under-positioned and cheap. It also is in a very stable domicile, which is not necessarily affected by energy crises or the Russia-Ukraine war.
- Latin American countries. They are well positioned as they're trying to stabilize inflation, and they’re major energy or commodity exporters;
- China equities. Chinese firms could potentially benefit from access to commodities from Russia at a preferential price, given the geopolitical shifts and alliances that we're seeing. In addition, nevertheless the pace of growth in the country is slowing, the quality of growth is improving, and Macquarie Research department forecast that in 2030 the Chinese economy will become the world’s largest one;
Talking about thematic diversification, instead, We should focus particularly on the following areas:
- Companies with superior ESG ratings. Stocks of ESG leaders are already earning higher multiples, on average, than ESG laggards, which may prompt more capital to flow toward companies with better ESG practices and funds incorporating ESG considerations.
- Specialized Real estate. In particular, real estate will grow close to digitalization, thanks to the need for towers and data storage centers, warehouses and logistics centers to support the shift to ecommerce, specialized laboratories, and more studio space due to the increased media content requirement . In addition, The World Economic Forum, has called out real estate as the sector with the highest energy usage and most significant CO2 emissions, hence more green technology in buildings and operating assets will be incorporated;
- Cryptocurrencies, which, despite their volatility, are considered to be becoming a good investment for their diversification, inflation hedges and growth assets. More and more institutions like JP Morgan or Goldman Sachs are starting to accept them.
- Companies involved in genome sequencing, precision medicine, tech-enabled procedures and digital health care.
Conclusions
In conclusion, in a period of high inflation, uncertainty and new developing opportunities, the best asset strategy allocation seems to be the dynamic one, with which we can constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens.
Moreover, the change in the geopolitical landscape, the particular attention to existing commodities and to new renewable resources, and the acceleration of the 3Ds phenomena (Decentralization, Decarbonisation, Digitalization), will boost growth across different parts of the world towards many industries and at different peace, leading to difference in monetary and fiscal policies.
The dynamism brought about by these changes will remodel the economic outlook and present great opportunities for investors.
Sources
- Financial Times
- Youtube
- Bloomberg
- Exchanges at Goldman Sachs
By Federico Farante and Elena Di Ceglie