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Do portfolios need to be built differently? · On The Money

• 0:03
  Speaker 1: Hello. I'm Kyle Caldwell and this is On The Money, a weekly look how to get the best out of your savings and investments. So in this episode we're gonna be looking at why investors should be considering a potential new regime of inflation being more uncertain and volatile over the next decade. So according to our guest, this backdrop will make it more challenging for the sixty forty portfolio, which is 60% in shares and 40% in bonds, which is the way in which a lot of multi asset funds invest. So we've covered in a previous episode the podcast, the sixty forty portfolio, which and that episode in September 2023 looked at whether the strategy is still fit for purpose.
• 0:45
  Now in this episode, we're gonna take a fresh look at the renowned investment strategy and also cover some more practical pointers in terms of what investors should be considering in terms of asset allocation. Joining me to discuss the topic is Tom Hibbers, multi asset strategist at Canaccord Genuity Wealth Management. To kick off, Tom, could you give a brief overview of the $60.40 portfolio and why up until a couple years ago in 2022, it largely been successful in terms of giving investors relatively solid betains over the long term and at the same time, quite a smooth ride?
• 1:26
  Speaker 2: Sure. Absolutely. Thank you, Kyle. So, the sixty forty portfolio, as you suggest, it's 60% in global equities and 40% in global bonds. It stems from modern portfolio theory, which is central to how most multi asset investors build their portfolios today.
• 1:42
  It's a passively managed portfolio. So you essentially set your asset allocation at sixtyforty, and then you can go on holiday fundamentally. And so it requires very little, it's totally passively, managed. So there's all you do is rebalance the portfolio. It's been a fantastic investment strategy over the last sort of forty or fifty years, mostly because inflationary pressures have been low.
• 2:06
  And the theory is really built around the complimentary relationship between equities and bonds. So during periods of strong economic growth, obviously equities perform well in that environment. And at the same time, central banks are hiking interest rates. So it's, bonds, you still make a positive return, hopefully, but, but it's more of a headwind for bonds. Whereas during recessionary scenarios, equities obviously struggled in that environment.
• 2:31
  Central banks cut rates to stimulate the economy and bonds perform well in that environment. Also investors during those recessionary scenarios flood or or fly towards safe haven assets, and that benefits bonds as well. So it's built around this really beneficial complementary relationship between equities and bonds.
• 2:49
  Speaker 1: So let's discuss why this complementary relationship didn't work in 02/2022. So this was a year that, of course, we saw interest rates rise. Inflation was red hot. And the sixtyforty portfolio made a loss that year, an unusual loss over a twelve month period. Could you explain why bonds didn't fulfill their role that year in terms of giving a portfolio defensive qualities?
• 3:17
  Speaker 2: Sure. So I think to understand, that that environment, first, you have to go back to the global financial crisis. I'll do it in the moment. But 2022 was the first year in modern history when both equities and bonds were down together in the same year. So highly, highly unusual.
• 3:34
  To understand what happened, you have to go back to the global financial crisis during which central banks cut interest rates to effectively 0%, And they adopted these ultra loose monetary policies, including quantitative easing, where central banks were injecting liquidity into the market by buying illiquid government bonds and replacing them with liquid but that meant that artificially bond yields were very low. So they offered very little value and there was very little room for central banks to cut interest rates further when you had a recessionary scenario. And at the same time, they were very exposed to rising interest rates if there was a bout of inflation. Now that decade was happened to be where there was very little inflationary pressures. But suddenly during the pandemic or post pandemic, when you had, a third of global government bonds, for example, trading with negative yields, that meant you had your investors were paying for the privilege of let of lending money in that environment.
• 4:32
  When you had inflation and interest rates began to rise, both equities and bonds were very exposed to that at the same time. And you had this terrible drawdown where equities and bonds both fell together. And it was the worst year on record for multi asset investors. And, yeah, it's it's uphill from here.
• 4:48
  Speaker 1: You mentioned that around the fears of bonds were in had negative yields, which was quite remarkable looking back on that. Now looking ahead today, one thing that's happened following the interest rate rises that have taken place, and there's been some interest rate cuts relatively recently, is that bonds are now offering attractive yields, the most attractive levels in well over the decades. I've seen some commentators say that this could actually make the case for the $60.40 portfolio being reborn given that investors are actually in a decent level of income from the bond market. However, your view is that the elephant in the room is inflation, which you expect over the next decade to be higher on average, more uncertain, and more volatile. So could you explain that for you?
• 5:35
  Sure.
• 5:35
  Speaker 2: And I I don't think that those commentators are entirely wrong. I think the sixtyforty portfolio has been reborn to some extent in in that bonds will provide diversification if you get a demand side shock or a recession. They will provide value and and dampen equity volatility. But as you suggest, inflation is, the elephant in the room. I envisage a market regime where inflation is gonna be more volatile, and higher on average.
• 6:03
  And and really, there there are two key reasons for that. One is that, we have this excessively loose fiscal policy. Governments are spending lots of money that is keeping services inflation elevated. And as we know, our economies, particularly The US and The UK, are very services heavy. Services is not as sensitive to interest rates as other areas of the economy.
• 6:28
  And the manufacturing to services ratio post the Second World War in The US was one to two. It's now one to eight. So I think that monetary cycles are becoming less efficient, and that fiscal policies are becoming more dominant. That's as as long as as long as we don't have fiscal consolidation, which I think isn't looking, very likely at the moment, although we have Elon Musk's Doge, I I expect, inflation to be high on on the back of that. And at the same time, a lot of the megatrends of the last sort of forty or fifty years, things like, the emergence of China onto the world stage, global trade, It was a period of relative peace, women entering the workforce, the invention of the internet.
• 7:11
  All of those things were very deflationary. A lot of those things have now happened or are outright reversing. So we've now got trade wars, tariffs, protectionist policies. And fundamentally, we also have to make an energy transition, which I think will be inflationary.
• 7:25
  Speaker 1: So if bonds and shares are not gonna have the same relationship in the future as they have done in the past, What types of investments should people be thinking about? What's on your radar? Professor Pieter (zero
• 7:35
  Speaker 2: fifty seven): So I still think fixed interest has a place in portfolios during inflationary periods, just very selective areas of fixed interest. So asset backed securities are an area that we particularly like I can't afford for a couple of reasons. They have no interest rate duration. So as central banks raise interest rates, the income from those investments also increases. Also, as the name suggests, they're backed by physical assets.
• 7:59
  And if you have strong price trends, then you get extra protection from the rising prices of those physical assets. Commodities are a very good inflation hedge. I don't like any specific one commodity, but a broad basket approach to commodities does provide good inflation protection. I think the investment case for gold is very strong on a standalone basis. And I think gold is a sensible investment for inflationary regimes.
• 8:24
  Short dated inflation linked bonds are attractive. I think you need to understand how to invest in inflation linked bonds. They're quite a complicated asset class and they perform very badly in 2022, particularly ones with more interest rate risk. We prefer short dated inflation linked bonds that provide sensitivity to the inflation component rather than the interest rate components. But you do have to understand how they work and be cautious of the fact that if real yields are negative like they were in 2021, that you need to be conscious of what value is embedded in inflation linked bonds before you invest.
• 8:57
  Commodity related equities are a good inflation hedge. So the companies that produce and process the raw materials that will go into some sort of energy transition will be very good allocations for this sort of environment that I envisage.
• 9:11
  Speaker 1: In terms of asset allocation, so rather than the normal sixtyforty portfolio, would you be an advocate of those sort of defensive investments that you just talked through? Would you advocate that people should think about having a portion of their portfolio within that allocation? And you may not be able to give sort of a percentage weighting. What should people be thinking about in terms of how much to allocate?
• 9:34
  Speaker 2: So I think the allocation, a lot depends on your risk profile. And also, I think you should be active as a starting point. So when the risks are tilted towards the demand side, you want to lean into traditional fixed income characteristics that can give you that protection if there is then a recession. Whereas if the risks are tilted towards the supply side, you want to be tilting towards those inflation sensitive areas. So starting point would be a relative equal allocation between those two sort of demand side assets and supply side assets, but tilting depending on on what the risks, look like.
• 10:11
  So, you know, within fixed income is a great example, actually, where, you know, at the moment, for example, when risks are relatively tilted to the demand side, we think it's worthwhile improving your your average credit quality, moving towards high quality sovereign bonds, and reducing those other high credit risk areas that don't give you those sorts of characteristics. So prioritizing those traditional fixed income characteristics.
• 10:36
  Speaker 1: And in terms of the commodities exposure that you mentioned, is it through an exchange through the commodity form that you'd seek to gain that exposure?
• 10:43
  Speaker 2: I think that's a very sensible way of doing it because it gives you the sensitivity to the commodity complex. The problem with just a passive tracker is that you have to pay there's a cost for the implementation of, let's say, it's a swap based ETF, then there's a cost of implementation of the swaps. So you might get the return of the BCOM with very little tracking error, but you'd consistently underperform, by a little bit over time. And that obviously adds, accumulates as as as time goes by. And there are other problems with just a a passive approach.
• 11:17
  So the the commodity index, for example, is production weighted. So, obviously, you'll then overweight commodities where there's more supply. I don't think that's the best starting point for for an investment portfolio. So you might want to tilt towards commodities that are are more supply constrained, for example. So I think there are good ways of investing in commodities actively, although passive, I think, would give you the inflation sensitivity that's required, but I think there are better ways of doing it.
• 11:43
  Speaker 1: I also wanted to ask for your thoughts on the threat of stagflation in The UK. It's actually made some front page news recently. How much of a risk do you think the prospect of stagflation is, and what can investors do to protect their portfolios? I appreciate we probably could have done the whole episode just on this one topic, but I'm only giving you a couple of minutes to answer it. But, yeah, over to you.
• 12:06
  Speaker 2: Yeah. Sure. It's a very real risk, I think, and we're already heading there. So this week and and the episode, I think, will come out after after the data point, but, economic growth is expected to slip into contraction in the fourth quarter. If that is the case, obviously it will continue to add pressure on this new Labour government.
• 12:24
  Although they they talk about growth, I don't think that their policy agenda is really directed towards creating growth. And at the same time, inflationary pressures still persist. So stagflation, where you have low economic growth and high inflation at the same time, I think is a very real risk for this UK economy. And in that environment, we think inflation linked bonds are a very attractive asset that can, you know, protect in a low growth environment, but also they have that inflation component as well.
• 12:51
  Speaker 1: And with inflation linked bonds, do you prefer the direct approach of owning them directly, or would you seek to own them through a fund or an index fund?
• 13:00
  Speaker 2: We use ETFs. We there are specific ETFs that can be quite targeted on your exposure. So at the moment, we prefer short dated, TIPS in The US, which provide more attractive, real yields. TIPS do. In the fourth quarter, we've seen quite a changing in where the real yields are more attractive.
• 13:18
  So we are now looking at maybe extending duration a little bit further out the curve where there are higher real yields. But for most of the time, I would advocate staying short dated in TIPS to give you that sensitivity to inflation rather than interest rates.
• 13:31
  Speaker 1: And thanks to Tom, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app and do tell a friend about it. If you get a chance, leave us a review or a rating in your podcast app too. Enjoy the conversation, ask questions, and tell us what you'd like us to talk about via email on 0tm@ii.co.uk. And in the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website, ii.co.uk.
• 14:00
  And I'll see you next week.