Rethinking the traditional 60/40 portfolio
Key points
- The 40-year secular bond bull market ended in 2022. In a mirror opposite to the 1980s, today’s investors will not realize this until a new era of rising yields has already begun
- Resurgent inflation and growing deficits have ushered in an era of fiscal dominance, disrupting bonds’ traditional role as a safe haven, while the term premium remains elevated
- US fiscal health is on thin ice as structural spending and debt levels are pushing the US toward unsustainable territory
- As central banks shift their focus to gold, bond markets lose their major price-insensitive buyers. This leaves mostly price-sensitive investors, making bond prices more volatile. Portfolios must evolve in this new inflationary regime. Investors should recalibrate their portfolio allocation by increasing gold and tangible assets like commodities for diversification and defense
We believe a major secular shift is underway in financial markets as seen in global interest rates, inflation levels, and currency prices. This change is driven by strained sovereign debt levels, escalating geopolitical risks, and a subtle but gradual shift in the relationship between business and government.
What has worked since the Great Financial Crisis (GFC) might not work in this new emerging era. The demand for real returns, diversification, and safety will lead to increasing demand for tangible assets such as gold and broader commodities.
Background
As exciting as the stock market is to watch for many, the bigger story is unfolding in the bond market. Bonds have been thought of as this boring space where investors clip their coupons and benefit from their stability in times of market volatility.
However, the relationship of bonds being the ballast in a diversified portfolio is shifting due to a new inflationary regime of rising government debts and deficits driving interest rates higher.
The US led the world in launching fiscal spending bazookas during the pandemic to support the private sector. This spending was at war-like levels and was possible by increasing the government’s budget deficit – ushering in the era of fiscal dominance, where government borrowing begins to drive the economy, crowd out the private sector, and makes monetary policy less potent. This fiscal dominance will gradually, but assuredly, push interest rates higher as borrowing levels increase and treasury buyers become leery. The world has awakened to the unsustainable nature of US budget expenditures – most of which are non-discretionary such as social security, defense, Medicare and Medicaid.
It’s not a crisis yet – but we need to start focusing on the debt balance before it becomes a crisis. The US is at the point where you realize that your credit card balance has become too big to keep spending at the current rate.
With interest rates well above the near-zero lows last seen in 2021 and higher projected deficits, there is an increasing amount of US debt that needs to be rolled over at a higher interest rate. That is an unsustainable mix.
Short-term reprieve masking long-term risks
Inflation has been edging down; however, our view is that this decline is before the impact of tariff price increases and stubborn energy prices shows up in the data. Furthermore, while recession fears may push short-term rates lower, we believe that long-term rates may not come down as much proportionately due to concerns of the high deficits. The US is looking at long-term secular rising interest rates. Something needs to give – such as a “Liz Truss” moment where bond yields jump on too much debt needing to be issued.
Possible policy fixes
History and math show that there are few unappealing choices facing policy makers. We all live in a world of choices that are bound by constraints.
Some of us may recall from our Macro Econ 101 class on how policy makers can address high government debt and deficits using four options:
- Defaulting
- Initiating austerity
- Grow the economy faster than the rate of debt growth, or
- Decrease the real value of the debt through inflation/monetization
While option one, defaulting, is an extremely unlikely scenario, we feel that the more likely scenario is a combination of the remaining three options. While austerity is a low probability outcome at this stage, the chances of a mix of spending cuts and tax increases could rise if there is a tipping point or a bond market revolt.
The heavier emphasis will likely be on inflating our way out of the debt burden while trying to create incentives for productivity boosts. AI has the potential for pushing productivity higher and helping us grow out of the debt – akin to an individual increasing their income higher so that the debt level becomes manageable. But just as in our personal lives, it is easier said than done.
Factoring in these scenarios, we’re likely looking at benefit cuts, higher taxes, and higher inflation over the next several years as the US addresses these unsustainable imbalances.
Possible policy response scenarios to high debt
Facing reluctant buying of long bonds, the Treasury department will be forced to restart issuing short-term bills to meet the funding needs – a new set of buyers seems to be lining up through the increasing footprint of Stablecoin issuers alongside the existing money market funds.
If there is a wider economic air-pocket, then the Fed will likely step back in and restart QE (quantitative easing) as well as requiring banks to hold more treasuries on their balance sheets.
Large-scale issuance of short-term debt, politicizing the central bank and QE resembles policies often seen in emerging markets, which can weaken the currency and fuel inflation.
Market impacts
So, what does all this macro stuff mean for financial markets and portfolios? We believe that the 40-year bond bull market ended in 2022 and that bonds, especially long bonds, are in a secular bear market that will unfold over the next several years. The path might not be too dissimilar to the 1970s.
As illustrated in the quadrant above, an inflationary and weakening environment benefits commodities, especially gold. A portfolio allocated to tangible assets that cannot be inflated or debased away, such as gold, gold mining companies and broader commodities, can benefit from the potential risks of bonds and long-duration stocks.
This view is the foundational factor driving our return to tangibles secular theme and strategy. We believe the market will come to our position and tangible sectors and assets will lead the next secular theme.
“The bond market is the mirror opposite of the 1980s” ~
Stanley Druckenmiller
Bottom line
The classic 60/40 portfolio may no longer offer the protection it once did. With rising inflation, growing deficits, and less demand for government debt, bonds are losing their reliability.
In today’s environment, real assets like gold and broad commodities may offer better diversification and inflation protection as economic and policy pressures build.
