Not an optimal investment allocation

Bob Greer and John Cavalieri at Pimco have put together an interesting article that drives yet another stake into the investment thesis favored by Money Magazine. That is, a portfolio that would have "buy and hold" investors allocating more than two-thirds of their retirement money to stocks and continuing to do so indefinitely into the future, come what may.

While this worked well for the last twenty years of the last century, it ain't workin' in the new century, a reality that many are just starting to grasp after eight years.

Rising inflation during the last few years and more of the same in the years ahead is a central tenet in their thinking, one that would not appear to be a pressing concern at the moment amid historic declines in the Producer Price Index yesterday and the Consumer Price Index today.

But, these changes are seen as fleeting.

The low inflation of the last twenty years was more the exception than the rule and it's too bad so many in the West got so used to it.

The U.S. cannot rely forever on low Chinese labor costs to keep its own inflation under control.

Until this summer, we heard about rising commodity prices as well. We saw it most obviously at the gas pump, but in fact a very broad range of commodity prices increased. While there may be short-term dips, commodity prices are likely to rise over a secular timeframe. Infrastructure (supply, storage, processing, transportation) for many commodities is strained, and it will take many years and hundreds of billions of dollars for that to change. Before they provide this necessary investment, sources of capital will have to see high prices for an extended period of time, and believe that these high prices will continue. The current dip in commodity prices, however, has created uncertainty about the stable high prices needed for long-term investment. (It should be noted that the price declines resulted not from increased supply, but from reduced demand expectations due to the slowing economy.)
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Investment Implications
Critical to achieving a successful investment outcome are two key steps: 1) recognizing the underlying macroeconomic environment that is likely to define the investment horizon, and 2) aligning a strategic asset allocation accordingly. Specifically, investors should consider two fundamental macroeconomic variables – real economic growth and inflation – and further consider two possible states for each – high/rising or low/falling. This simple 2×2 matrix provides an intuitive framework for identifying the four basic states of an economy.

Once investors identify the most likely current and forthcoming states of an economy, they can then construct a portfolio that emphasizes assets that are likely to perform best in those states.
With this framework it becomes clear that the simple stock-bond mix that has come to define a “core” or “balanced” allocation falls short of diversifying investors across the four possible macroeconomic states. Specifically, the stock-bond mix only makes sense in a low or disinflationary world, and only if the investor has ruled out the possibility of a handoff to higher inflation. Given PIMCO’s secular outlook, which explicitly calls for a regime shift to a world of rising inflationary pressures, this allocation approach is not optimal.

This forces a simple question: Why would the broad investment community allow such a glaring omission in a strategic asset allocation?

The answer appears to be driven by the shared and rather homogenous disinflationary experience of today’s investment community. Specifically, for the last quarter century, developed economies have experienced a virtually uninterrupted period of disinflation. Beginning in the early ‘80s, inflation has steadily declined in developed economies from the teens to the “Goldilocks” level of 2%–3%. Since inflation was in secular decline, the only economic variable in play on our 2×2 matrix was the level of real growth. Therefore, it made perfect sense for investors to focus on stocks and nominal bonds within their core portfolio, since they only needed to be diversified with respect to the level of real growth in a disinflationary context.

What made perfect sense in the rear-view mirror makes less sense when looking through the windshield and seeing a future more likely to be defined by rising inflation than falling inflation.

When we eventually dig ourselves out of the deep economic hole we've fallen into and inflation begins to heat up again, watch Money Magazine for clues as to how the thinking of your average retail investor has changed.