As we saw in the 1970s, inflation is the beast that will eat your 60:40 portfolio and eviscerate your risk-parity portfolio too. Anyone running a traditional asset allocation for their clients should rightly fear it. Yet, inflation itself has felt such an unrealistic prospect because of the structural disinflationary forces that have surrounded us for the past 40 years.
In 2020, the Rubicon of macro policy regimes was definitively crossed. Governments are unlikely to be able to repeat their post-2008 efforts at austerity, particularly while the scarring effects of Covid remain evident in unemployment. ‘Balancing the books for the next generation’ is losing its traction to a combination of Modern Monetary Theory and ‘greening the economy for the next generation’.
Last August, the US Federal Reserve published its monetary policy review. The conclusion in not-so-many words: after a period of below-average inflation, we will let inflation overshoot to the upside, to ensure our employment mandate is met. Or, more simply: we will run the economy hot because we don’t think inflation is an issue, and we want to get back to full employment.
The Fed, and most other central banks in the developed economies, have come to fear deflation more than inflation. They are more confident in their inflation fighting capabilities than they are in their deflation-beating ones. They all fear Japan’s experience over recent decades.
Investors’ generic fear for portfolios today is that bond prices can’t rise much more and so they won’t be a good hedge in portfolios. This is overly simplistic.
First, it ignores the possibility of negative nominal interest rates, something we see as unlikely but not impossible. More important, it ignores the key question: what drives the bond-equity correlation, and what conditions will turn it positive again? Put simply: when will bonds stop providing an offset to equities in a portfolio?
Inflation is the beast that will eat your 60:40 portfolio and eviscerate your risk-parity portfolio too.