An Inflationary Era Requires Taking a Road Less Traveled (If You Are Seeking a Positive Return)
Part II of Volume I, Issue IX
Blame the Fed, war, and fiscal profligacy all you want. But big trouble was lurking in many widely followed portfolio strategies long before those threats took hold. That’s the upshot of new research that uses a yield-derived valuation model to show the famous 60/40 allocation reached its most expensive level in almost five decades during the Covid-19 rally.
The situation has reversed in 2022, which is now by some definitions the worst year ever for the bond-and-equities cocktail. The data is a harsh reminder of the primacy of valuation in determining returns.
- Bloomberg, October 19, 2022
Editor’s Note: This is Part II of Volume I, Issue IX of The Macro Value Monitor. Part I, Reflections on Abrupt Pivots and the Creeping Consequences of Great Mistakes, can be found here. A full PDF of this issue is available here.
The arrival of the first bout of persistent inflation in four decades has transformed the market landscape, and in doing so it has challenged principles long considered to be ironclad laws of investing by generations of investors. There has not been a more significant pivot since the early 1980s, when the markets began to transition away from the high inflation rates of the 1970s.
This time, however, the markets are transitioning away from the threat of disinflation/deflation into a more inflationary environment.
In the wake of this year’s pivot, it seems professional and individual investors alike have been questioning their approach to the markets, and rethinking many of their planning assumptions – and they are right to do so. Investment strategies which were reliable when inflation was stable have been revealed to be surprisingly fragile when inflation unexpectedly rises. Assessing whether an approach will recover its footing or continue to be fragile and loss-prone is an exercise every investor should be undertaking right now.
In conversations throughout this year, however, I have observed that many investors are not asking the one question they should be asking. Instead of asking whether they should have more in stocks, or more in bonds, or perhaps less in both and more in cash, investors should be asking whether there are asset classes beyond stocks and bonds that should be incorporated into their investment approach.
The answer to that question is an emphatic yes.
In June 2021, I published this memo, which detailed the record low yield a portfolio of stocks and bonds was providing investors at the time. We have discussed this issue at great length, but the record low yield in 2021 was a risk that few investors were paying attention to as inflation rates began to rise. The main risk was that if higher inflation rates were not transitory and continued to rise, the yield of stocks and bonds would eventually rise as well, and a new trend of rising yields would likely result in large losses to investors in stocks and bonds.
Since that memo was published, the combined losses in stocks and bonds have been the largest in more than half a century. The public debate throughout this hostile devaluation has been centered around how high inflation rates may go, how long elevated inflation will last, and how high interest rates will be increased in response. The answers to these questions are critical for investors in stocks and bonds, as a recovery in their portfolio is dependent on inflation subsiding.
Yet for investors who look beyond stocks and bonds, the outcome of the current bout of inflation is less critical for the long-term growth of their portfolio. These investors know that even during the long periods when inflation ravaged investment portfolios in the past, as it did between 1970 and 1982, a portfolio which remained diversified beyond stocks and bonds still provided growth.
Keep reading with a 7-day free trial
Subscribe to The Macro Value Monitor to keep reading this post and get 7 days of free access to the full post archives.