The 60/40 portfolio is showing signs of duress, and retirees are paying the steepest price!

The traditional 60% equity, 40% fixed income portfolio is once again going through a rough patch since the Iran conflict broke out at the end of February. Indeed, as of March 20th, a Canadian investor with a 60% weight to the Vanguard All-Equity ETF Portfolio (“VEQT”) and 40% to the iShares Core Canadian Universe Bond Index ETF (“XBB”) would be down roughly 5.6% month-to-date:

The fixed income portion of the portfolio, supposed to provide investors a source of diversification during equity drawdowns, has also experienced losses. Indeed, inflation is once again back on investors’ radar. Oil and natural gas prices have gone up, having a direct impact (on prices at the pump, for example), but also second-order effects (increase in input prices, inflation expectations, etc.). Governments will also need additional spending to finance the conflict and/or additional military spending in a more dangerous world.

An unexpected rise in inflation or in inflation expectations is never good news for long-duration bonds, a pillar of the 60/40 portfolio. Investors rightfully ask for additional compensation for holding longer term bonds in an inflationary environment, because the future nominal value of the bonds is being eroded by inflation. This translates to bond prices going down, and yields rising.

Now, it’s important to note that this is a very short period; a quick resolution to the Iran conflict might lead to a quick bounce-back in both equities and fixed income. However, the 60/40 portfolio is now a repeat offender; it also disappointed investors in 2022, when both equities and fixed income went down in lockstep:

Going even further, the fixed income component of the portfolio has generated negative total returns for over five years, and only about 1.6% compounded annual return over a 10-year period. Inflation, during those periods, has eroded purchasing power by over 20% and 30%, respectively¹

This has serious implications for all investors, but even more so for retirees, who potentially got hit three ways:

• A generally higher allocation to the underperforming fixed income asset class;
• Eroding purchasing power as inflation increases their fixed costs (groceries, transportation, healthcare, etc.);
• Crystallizing losses if they needed to withdraw from their portfolios for their living expenses

Looking forward, though, the portrait is a bit less dire. Thanks to the mechanics of bond ETFs, we can imperfectly approximate the absolute return of a diversified bond index like the iShares Core Canadian Universe Bond Index ETF. Its expected return over its average duration (~7 years) should resemble its current yield-to-maturity (~4.2%). This is much better than the 1.6% CAGR we have seen over the last 10 years. However, if inflation continues to surprise to the upside, the real return would diminish.

But the past is the past. The question that comes to mind now, is: has something fundamentally changed?

Well, I’m of the opinion that it has. We now live in a different world than earlier in the century. Many new realities are pointing to a more vigorous fight for scarce resources, and, consequently, higher inflation:

• The China “dividend” is mostly gone: China’s entry into the WTO in late 2001 had a significant deflationary effect on global goods prices, as manufacturing was offshored to benefit from lower labour costs. According to the National Bureau of Economic Research², China’s WTO entry led to a 7.6% reduction in the U.S. manufactured goods price index between 2000 and 2006.

Since then, a lot has changed. Many companies are either reshoring, nearshoring, or diversifying away from China (ex: “China Plus One” model). China (and Asia in general) has also developed quickly and no longer offers the kind of cheap labor that was ubiquitous earlier in the century.

To the contrary, China’s growing wages, urbanization, and affluence, is increasing consumption of goods and services, which can have an impact on the prices of raw materials over time.

• The peace “dividend” is also gone: With Russia invading Ukraine in 2022, Hamas attacking Israel in 2023 (and the resulting armed conflict in Gaza), and the most recent conflict in Iran, the relative peace of the past few decades seems a bygone era.

Russia, China, and even the US governments have also shown ambitions for territorial expansion. Canada, Europe, and Asia are catching on that they must increase spending if they want to be able to protect themselves. These expenditures are costly, increase demand for resources, and add to already high deficits.

• AI is inflationary over the short-term: There is a massive capex boom to build out the infrastructure needed to support artificial intelligence. Just four companies (Alphabet, Microsoft, Amazon, Meta) have earmarked ~700 billion dollars for 2026 capex, while data center capex is expected to reach 1.7 trillion by 2030³.

This will translate into heavy demand for various resources, from electricity to copper, aluminum, rare earths, and more, for many years to come.

• Government debt has increased dramatically, and bond investors are growing nervous: Most governments are now running elevated budget deficits, and instances of bond investors “fighting back” are more common. For example, the “Mini-Budget" Panic in the UK in 2022, the historic long-term bond yield increase in Japan since 2022, and the France political and fiscal crisis of 2024 are all examples of investors asking for more compensation for lending to heavily indebted countries.

Most of these elements reinforce each other and point to inflation being a legitimate worry over the coming years.

So, if financial advisors or investors are worried about inflation in the future, what can they do? Well, exploring ways to add resilience to their 60/40 portfolios is definitely a worthy exercise.

But first and foremost, advisors must consider matching duration with client cash flow needs. A short-term cash-like sleeve or bond ladder significantly reduces the risk of crystallizing losses in a market where both stocks and bonds have corrected.

For example, if client A, a retired Canadian resident, needs 50,000$ for his/her 2026 living needs, and 55,000$ for 2027 expenses, an advisor could consider earmarking 50,000$ into a cash-like product, while investing the funds required to generate 55,000$ into Canadian government bonds that mature in early 2027 (or before the expected cash withdrawal date(s)). That way, the payoff is perfectly aligned to cash flows needs, both in amounts and timing.

For longer-term investments, an advisor or investor can explore specific alternative investments for additional portfolio resilience. The objective here is to create an uncorrelated source of returns that can potentially add value when both stocks and bonds are showing losses. For example:

• Agriculture & Farmland: Owning farmland provides an intuitive protection against inflation. If everyone is fighting for scarce resources, well, owning the means to produce these resources is a built-in hedge. Farmland has historically generated positive real returns with a low or negative correlation to both stocks and bonds⁴.
• Insurance-Linked Strategies: A relatively new, but growing asset class in terms of popularity. “Catastrophe bonds” are the best-known securities in this space, although options go far beyond that. However, the exposure profile is intuitively uncorrelated: payoff depends on weather events as opposed to earnings and interest rates. Note that the vast majority of ILS are floating-rate, so duration is generally not a major issue.
• Infrastructure lending: This represents lending to projects like toll roads, power plants, transmission lines, water systems, or data centers, among others. These are typically senior secured loans with the physical asset as collateral, and the borrowers often have contracted or regulated revenue streams. The cash flows are often inflation-linked, either explicitly (through agreements that index payments to inflation), or implicitly (periodic rate adjustments). That gives it a natural inflation hedge against rising rates that conventional bonds lack.

It’s very important, though, to understand the liquidity profile of these investments. Farmland and Infrastructure, for example, tend to be low liquidity instruments, so they may be a less interesting option if the client has significant liquidity requirements in the years ahead.

Understanding the risks in these products is also paramount. Farmland is not all created equal. For example, excessive use of financial leverage, or exposures in countries with weak rule of law, can subject infrastructure or farmland to financial risk and geopolitical risk, respectively.

ILS strategies can also show large, asymmetric losses in case of severe natural catastrophes.

Manager performance and fund structures can also vary wildly. Dispersion of performance between top-quartile and bottom-quartile managers can be significant, while fund structures (drawdown funds, semi-liquid funds, etc.) carry unique characteristics and risks.

The financial advisor or investor also needs to look at the total fee component. Alternative strategies tend to come with much higher “all-in” fees, be it through higher management fees and/or performance fees.

And finally, alternative investments can also be difficult to access for some investors. High minimum investment amounts can notably exclude many “Do-It-Yourself” investors from these types of strategies.

Besides alternatives, there are also options on the public markets, although they may come with significant drawbacks:

• Floating rate bonds: Because their coupons reset with short-term rates (typically a risk-free rate plus a spread), they have near-zero duration. That makes them excellent in rising-rate environments. But the trade-off is substantial: credit risk. Most floating-rate instruments are linked to below-investment-grade borrowers.

Floating rate government notes strip out the credit risk component, but do not provide investors with much additional yield versus a traditional bond ladder; There is no free lunch in finance!

• Real return bonds / TIPS: Real return bonds adjust the coupon according to realized inflation. However, they come with a major drawback: duration risk. For example, even in a rising inflation environment like 2022, Real return bonds in Canada lost more than 10%⁵ because of the sharp increase in nominal rates.

When we take this all in, the natural conclusion is that financial advisors and investors are now facing a difficult decision: should they stick with their 60/40 portfolio hoping for a better outcome in the future, or try to bolster resilience through strategies that may come with additional complexity, risk, and fees?

The answer is not straightforward. Having a trusted investment advisor with your best interests at heart in your corner to navigate this difficult market environment may, however, be the best option, here.

^{[1] Source: Bank of Canada seasonally-adjusted CPI: https://www.bankofcanada.ca/rates/price-indexes/cpi/
[2] Source: NBER: https://www.nber.org/digest/aug17/how-chinas-wto-entry-led-lower-prices-us?page=1&perPage=50
[3] Dell’Oro Group: https://www.delloro.com/news/ai-boom-drives-data-center-capex-to-1-7-trillion-by-2030/
[4] Source: FieraComox. 2002-2022 farmland correlation with US equities: -0.18, and with 10Y US treasuries: 0.10
[5] For example: The iShares Canadian Real Return Bond Index ETF (“XRB”)  lost 14.9% in 2022 (source: Bloomberg)}

^{The views and opinions expressed in this article are those of the author, a Portfolio Manager at Bold Wealth Partners Inc. (“Bold Wealth”), and are provided for general informational purposes only. They do not constitute investment advice, financial planning guidance, or a recommendation to buy or sell any securities or financial instruments.}

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