There has been much discussion as to whether the 60:40 model – comprising a portfolio 60% invested in equities and 40% in bonds – is dead. Given how well this model has served private investors over the past 40 years, we can understand why such pronouncements are a cause of grave concern. Unfortunately, we think those pronouncements are correct.
In the 60:40 model, bonds served two roles. First, they provided an attractive running yield. Second, thanks to the negative correlation between stocks and bonds, they rose in value when equities sold off, resulting in decent returns with moderate volatility.
Today, things are very different. Bonds offer nugatory returns. Worse, the capital gains that an investor might expect from bonds during an equity rout are much more modest than they have been in the past: as yields approach the zero bound, nominal yields can only fall so far.
However, investors need not despair. With modest adjustments, we think the 60:40 model can remain relevant by changing the allocation from nominal bonds to index-linked bonds. Whereas nominal bonds are substantially tethered to the zero bound, index-linked bonds have no such constraints. We see no reason why they cannot trade on substantially negative yields.
Post-pandemic, what stands out are debt levels not seen since the Second World War. The solution now, as was the solution then, is an era of financial repression. This means holding interest rates below the rate of inflation.
The required reduction of debt, relative to the value of assets and income, can be achieved quickly through a short burst of very high inflation. This was the case in post-war France until 1950, or more slowly in the US and UK until 1980. Holding interest rates below the rate of inflation implies strongly negative real interest rates, which means capital gains for index-linked bonds.
The rising tide
Inflation is not just necessary; we think it is probable. The global economy has been in the grip of three powerfully deflationary forces in recent decades: demographics, globalisation and technology.
Demographic forces move very slowly and so their effects are barely perceptible. Over time, though, they can be very powerful. As populations age and the ratio of dependents to productive workers rises, there will be fewer people available to provide the goods and services society needs. In recent decades, emerging economies joining the global workforce provided a massive supply shock, which eviscerated the bargaining power of labour in the developed world.
As untapped pools of labour in emerging economies dwindle, and wages converge with the developed world, the deflationary effect of globalisation wanes. This sets the stage to rebalance capital and labour’s share of GDP. Such an event will be inflationary and erode corporate profits.
Historically, inflation levels of 3-4% have been damaging to equities. But, in the past, a key transmission mechanism from inflation to lower equity valuations has been monetary policy that affects both the cost of borrowing and the discount rate applied to corporate cashflows.
Given current debt levels, central banks are likely to keep interest rates very low for years to come. But the erosion of corporate operating profits from higher labour costs and higher costs of replacing fixed assets demonstrates that inflation can be damaging to equity earnings without rising interest rates.
Investor portfolios must reflect the macroeconomic outlook. High starting equity valuations and a requirement for financial repression means, in our view, investors must hold a significant allocation to index-linked bonds.
Fortunately, a number of trusts offer exactly that, including my Capital Gearing Trust (CGT ), Ruffer Investment Company (RICA ) and Personal Assets Trust (PNL ). We would not be surprised to see more mainstream trusts follow suit.
Peter Spiller has managed Capital Gearing Trust for 39 years. He runs the portfolio with Alastair Laing and Chris Clothier and is chief investment officer of CG Asset Management.
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