The End of the 60:40 Investment Portfolio? How Inflation is Reshaping Asset Allocation Logic

Written by: Michael Howell

Compiled by: Block unicorn

Asset allocation is often done in a vacuum, with little consideration for the monetary policies investors will face. The standard approach is to establish a portfolio allocated in a 60:40 ratio, investing in stocks (risk assets) and high-quality bonds (safe assets). The rationale is that these two asset classes often show a negative correlation, especially during economic downturns.

Although this way of thinking forms the cornerstone of modern wealth management, it is actually only applicable in specific times and special circumstances. These periods lasted from the early 1980s until the global financial crisis (GFC) of 2008/09. This approach was not applicable in the 1970s and can be said to be not applicable today either.

The key to understanding wealth management and asset valuation lies in inflation. In short, while we all clearly wish to become wealthier, our main focus is at least on maintaining our real wealth levels. Assets should not be compared to one another (such as bonds to stocks), but rather should be compared to inflation.

Inflation can be a difficult concept to measure, but for the sake of illustration, let's assume it represents the loss of purchasing power of paper currency. Inflation can arise from monetary inflation, which is "printing money," or from cost inflation, such as rising oil prices and declining productivity.

The diagram below illustrates how inflation affects the valuation of different asset classes. The chart is illustrative, but empirical construction can be made using the long-term data published by Robert Shiller in the academic community on his website. We use data since 1880 in our version presented below. The curves are fitted using polynomial regression.

High-quality bonds (such as U.S. Treasury bonds) exhibit a monotonic relationship: as inflation accelerates, their valuation decreases (yield increases); as deflation approaches, their valuation increases (yield decreases). Textbooks also acknowledge this trade-off. Physical assets (not shown in the figure), such as residential real estate, land, gold, and perhaps Bitcoin, move in the completely opposite direction. As inflation accelerates, their valuation and prices also rise.

In contrast, the relationship between equities and inflation is more complex and nonlinear. This is not mentioned in finance textbooks. On either side of the 2-3% inflation "sweet spot" (when P/E valuations peak), both rising and falling inflation rates can lead to lower valuations. In other words, on the left side of this valuation peak, stocks and bonds are negatively correlated (in the "risk parity" zone) and positively on the right. Changes in correlation patterns require significant adjustments in portfolio construction.

Since the 1980s, most of our investment experience has been in a "low" inflation zone, primarily situated to the left of this valuation peak. This not only strongly supports a significant allocation to equities, but even slight changes in inflation rates have proven that holding bonds is reasonable, as they are negatively correlated with stocks. [Note the divergence in equity and bond valuation lines.] This is particularly evident during economic weakness or even when testing for deflation. Japan's history has demonstrated what happens to equity and bond valuations within a "very low" inflation zone.

However, this is not characteristic of the inflation period in the 1970s. At that time, physical assets were in high demand, while financial assets performed poorly. The reasons can be seen in the same chart. On the right side of the valuation peak, at around 2-3% inflation and above, both stock and bond valuations declined. Moreover, their decline was synchronous. This correlation weakened the case for holding both types of assets in a portfolio simultaneously. In fact, the contrasting and positive performance of physical assets against inflation strengthened the case for their inclusion in a portfolio.

Currency inflation rises

Our recent research has mainly focused on the accumulation of currency inflation risks, specifically the government's deliberate devaluation of paper money. [We hold a neutral stance on cost inflation.] The chart includes a rightward arrow as a reminder. In other words, the 60:40 asset allocation (or "risk parity" approach) is facing serious threats. Looking ahead, what investors should now consider is: reducing bond holdings and increasing tangible assets.

Indeed, the charts we have drawn show that the right tail of the bell curve for stock valuations is lower than that of bond valuations. Of course, this is not always the case. Unlike bond coupons, stock earnings and dividends may rise with inflation. The valuation trends of different stocks can vary, as some stocks are better at effectively hedging against inflation, which allows their valuations to remain at relatively high levels. On the other hand, many businesses struggle to maintain profitability in a high-inflation environment. However, what we are discussing here is the general situation, not the specific details.

Global bond yields are gradually rising. This is more driven by an increase in term premiums rather than higher policy rates. This suggests that the rise in yields may be caused by increasing inflation uncertainty and concerns that high government spending will lead to more coupon-bearing securities supply.

Looking at the market, we believe that the United States is currently facing greater uncertainty regarding inflation, both due to its large fiscal deficit and the expected increase in "business taxes" resulting from tariffs. More importantly, the fiscal deficit is increasingly financed by short-term securities, which raises the risk of monetary inflation.

Japan has recently experienced a rise in inflation, primarily due to increasing wage costs, but this comes after decades of deflation and intermittent deflation. In other words, placing Japan in the aforementioned chart, its stock valuations could rise to the "sweet spot" of an inflation rate of 2-3%. Clearly, at the current low levels, a 1.5% yield on Japanese government bonds (JGB) does not appear attractive.

China is currently in a deflationary phase following the "tariff shock," possibly at an earlier stage than Japan. The Chinese stock market is undervalued, but further monetary stimulus and a more robust economy could easily shift investors' sentiment back to the stock market.

At the same time, European equities are close to ideal "sweet spots" by inflationary standards, but they are somewhere between US and Asian markets. In other words, if inflation continues to rise (and we believe the world is headed for stagflation), then European equity valuations are more likely to follow the US and be gradually downgraded.

Asset Allocation Conclusion

The 60:40 or "risk parity" model, which has been favored by wealth managers for decades, faces severe challenges in an environment of monetary inflation. We tend to reduce bond allocations, or at least shift some bonds towards inflation-linked bonds (TIPS).

The portfolio should be tailored to the investor, but with a 60:40 benchmark for financial assets, we prefer to strategically adjust the portfolio to 60:10:10:10:10. Here, 10% may be allocated to TIPS; 10% in cash; 10% increases gold and precious metals, and 10% invests in Bitcoin. We exclude specialized physical assets, such as prime residential real estate and land, not because they are unattractive, but because they are less liquid and are often a permanent and non-tradable component of an investor's wealth.

A moderate rise in inflation may be beneficial for the overall stock market. In the above chart, we depict the nominal positions of different markets. It can be said that due to inflation issues in the U.S. economy, Wall Street "has peaked." Europe’s inflation rate remains moderate, while China and Japan are emerging from a deflationary/low inflation environment, which favors bonds over stocks. It might be worth investing in these Asian markets, but one should be cautious of their greater geopolitical risks.