The last decade was a fabulous time to own financial assets as events coincided to create a perfect environment of low inflation, low interest rates and ever-increasing central bank bond purchases.
This convergence translated into record-low bond yields, propelling bond prices to unprecedented heights and delivering handsome rewards to investors. Lower bond yields also lowered the returns required for equities, so valuations swelled – especially those of exciting growth businesses. Over short periods, bonds reliably counterbalanced stocks, but over the longer-term, they both went up.
However, the environment is changing, and we believe a sunset, driven by inflation, is coming. Long-term deflationary forces—waning labour power, globalisation, cheap energy, and the peace dividend—are now stopping or reversing. But what does this mean for your portfolio?
Markets are concentrated in the last decade’s winners
Looking at twelve valuation metrics over the long-term, one thing is clear – broad global stockmarkets are still expensive – they've only been more expensive 16% of the time on average of those metrics.
Meanwhile, global bond yields are not high by historical standards. Analysis by the Bank of England, going back 700 years, shows that global bond yields today are still lower than at almost any point in human history – apart from after the Second World War and in the past decade.
You may be thinking so what? But valuations matter over the long-term, for both asset classes. With equities and bonds facing a tougher environment, traditional 60/40 portfolios may have a challenging road ahead.
This would be less concerning if investors weren't so heavily concentrated in the past decade's winners. History shows that passive exposure often leads to concentrations in expensive areas just before those areas suffer. It also shows that the most overvalued assets crash the hardest when bubbles burst. This is concerning, given the current state of passive portfolios.
Global stockmarkets, and consequently passive strategies, are heavily concentrated in the US, giant companies, and technology shares. The magnificent seven – Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla – alone account for 19% of global passive portfolios. Also, two-thirds of assets in the Investment Association's (IA) 40-85% equity category are parked in passive strategies. Among active funds, around three-quarters of active funds are in growth strategies, only a quarter are in blend or value.
Holding multiple active funds that invest in similar things can be painful when trends change. Since many active funds in the IA 40-85% equity category are more than 90% correlated with the largest active fund, investors may discover they're diversified in name only.
Genuine diversification is key
So, how does one prepare? Firstly, you need to understand the type of environment to expect and the right tools to navigate it. While equities thrive in booms and bonds thrive in busts, the traditional 60/40 balanced fund offers little hope of outperforming cash in a stagflation scenario.
However, there are healthy alternatives. Investments in inflation-linked bonds and commodities can provide a hedge against stagflation, while undervalued stocks may mitigate equity market declines. For asset allocators, incorporating value-oriented investments into passive and growth-heavy portfolios can enhance returns and manage risk effectively, as seen in the past decade.
