Today, with bond yields now so low and inflation fears creeping in, investors are confronting the obvious concern. It is summed up well in this quote from Eric Peters of One River Asset Management: “The unprecedented policy response to the pandemic has forced investors to now build portfolios of risk assets without being able to rely on Treasury bonds to materially offset the negative convexity. Consequently, the industry now faces an acute shortage of portfolio diversifiers at a time when it must take ever more risk to achieve its return targets. And the unintended consequences are as profound as they are not yet fully appreciated, let alone understood.”
In short, are bonds still the low-risk, diversifying assets which their historical statistical characteristics suggest they are? And, if you’re feeling really jolly, you should re-examine the role of equities too. Shareholders are benefiting from receiving a historically-high proportion of stakeholders’ return. What’s more, that return to shareholders is being capitalised on very low interest rates.1 Both of these supports would probably be tested in an era of higher inflation. They will be further tested if, as seems likely, the political economy is tilted towards redistribution of wealth and income (resulting in lower margins).
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, as Jamie Dannhauser covers later in this year’s Review, inflation itself has felt such an unrealistic prospect because of the structural disinflationary forces that have surrounded us for the past 40 years.
We can all imagine the terror of facing a T-Rex. But the thought doesn’t linger for more than a microsecond because, well, they’re extinct. So too, apparently, inflation...