Over the past decade, investment advisors have made a good name for themselves by recommending investors and high net worth retail invest in a 60/40 portfolio, which is 60% Equities and 40% Bonds. Back testing this mix over the past decade made sense to advise clients to "hedge" their long market exposure. No doubt, when Equities fell, usually Bonds tended to go higher that helped the investor recover their Equity losses. The thing with statistics and correlations is that it is great when it works and when one finds a relationship, but it is also important to ask yourself "why does that relationship hold" and "under what cycle does the scenario make sense"?
Since the Global Financial Crisis, rates have just been coming down and the Fed has embarked on more and more QE. Today the balance sheet is north of $7 trillion after increasing it above $3 trillion earlier this year. We never even had a chance to shrink it years after the GFC and normalize interest rates. I mean the Fed tried to in December 2018 and we all know what happened that month: the markets collapsed 15% in a matter of days. So much to suggest this recovery is "stable". For the right or wrong reason, it is built on a house of free money in this case. If one were to look back to the late 1980s to today, U.S. 10-year bond yields have gone from north of 13% to about 0.65% today! That's despite all the cycles we have had over the past 40 years. Bonds only went one way, up, as the Fed kept buying even more. No wonder the 60/40 made so much sense as during all the mini busts, when Equities collapsed, Bonds held on and kept moving higher until the Equity caught up, making investors feel safe that they were hedged in two different asset classes.
That is truly well and great, but we have been in a deflationary period all this time. Post globalization and China entering the world market in full steam in early 2000s, the world has been faced with global deflation and lower prices. This is one of Fed's biggest worries as no matter how much money they pump in the system, inflation has never popped up, at least not since the 70s. But now that the world is getting polarized, and we are moving towards more insular and domestic economies, the world may be entering a period of inflation, as the general cost of consumption is going to move higher. With the Fed and central banks also printing money to no end, that will stimulate inflation even more. We are already seeing evidence of it creeping higher in cost of goods, even though it has not popped up in the Fed's measure of inflation. In a period of inflation, Bond prices tend to go down, not up! It is not an environment to own Bonds at all. The Fed is the only reason why the Bond market is holding up and pinned to the 0.6% level.
Since March this year, U.S. 10-year bond yields, for example, have stayed locked in a tight range around 0.6%. It has been a super boring market. Just this month as Equities have fallen 10% from their August highs, Bonds have done literally nothing. The 60/40 portfolio has not done well this month. It held up okay earlier this year because Equities rallied back up to their highs. But the "hedge" so to speak is becoming useless.
The Fed has not embarked on yield curve control as yet, and even if they keep buying Bonds, the inflation side of it will be capping its rise in effect making it an inefficient investment. If this inflation is met by low or slowing growth, that can be stagflation which is also negative for Equities. So, in this scenario, both Bonds and Equities can go down. This is something the actuaries or advisors have not accounted for in the new decade that is coming up.
Equities may be cheap and supported due to QE, but make no mistake that is because of monetary and fiscal stimulus. Let's call a spade a spade. And if we do get a genuine recovery, Bonds may still fall to reflect that. Either way, it is important to rethink one's hedge as just because it worked over the past does not necessarily mean it will in the future. Then again, advisors rarely get in front of a trend, they only start pitching it once its changed for good, but by that time it may be too late.