Over the last forty years, the 60/40 equity/bond portfolio’s performance was supported by muted inflationary pressures and declining interest rates. Now, the strongest inflationary pressures since 1980 (see chart) are forcing the Federal Reserve to tighten policy at the expense of growth.
Monetary policy tightening affects asset prices immediately, but it flows through to economic conditions at a lag. This makes it difficult for the Fed to calibrate tightening and engineer a soft economic landing - but that is what markets are pricing in. Five-year breakeven inflation expectations are back around target (see chart), but certain underlying economic measures such as earnings expectations suggest confidence that this can be achieved without hurting growth much further.
In line with a more rapid easing in inflation, markets are pricing in a halt to policy tightening in the next year or so (see chart).
This general uncertainty leaves the 60/40 vulnerable to inflation surprising to the upside or growth surprising to the downside from here, and both are possible outcomes. What is clear is that current market valuations skew towards the optimistic end of the spectrum.
For inflation upside protection, advisors may want to seek inflation-protected, or “real”, return streams, like inflation-linked bonds, private credit, and real assets (if they are capturing the right type of inflation). For growth downside protection, it might be wise to seek out alpha-generating alternatives to public equity allocations.
To explore how Opto can partner with you to help you and your clients achieve your goals, please get in touch with us at advisory-services@optoinvest.com.