For retirement security, clients should own inflation-protected bonds, said Nancy Davis, chief investment officer and managing partner at Quadratic Capital Management, an asset management firm in New York and Greenwich, Conn.
This was one of the opening remarks in a three-member panel discussion on asset allocation at Financial Advisor magazine’s Inside Alternatives conference earlier this week.
Davis explained that TIPS, or Treasury Inflation-Protected Securities, have “gotten really cheap” as people expect the Fed to get inflation in line. But Davis isn’t so sure that’s going to happen. In any case, these Treasury bonds provide long-term protection. When inflation rises, TIPS adjust their principal amounts upward to maintain their value.
Kristina Hooper, chief global market strategist at Invesco in New York, said investors had hoped the Fed would cut interest rate in the next year. But they are no longer optimistic about that. Instead, they are assuming that high rates will be around for some time, she said, which is creating market jitters.
Every new data point indicates rates could stay higher for longer—such as the most recent jobs report, showing more employment openings than expected—generates undue volatility, she said. “There is a heightened sensitivity right now,” she said. “But I do believe that markets are overreacting.”
Jack Ablin, CIO at Cresset Capital in Chicago, observed that inflation and interest rates tend to swing in 20- or 30-year cycles. He noted that the outsourcing of labor to other countries helped stave off a degree of inflation in the U.S. in recent years, but that trend has “played out,” he said, and is “already starting to reverse.”
This is among the reasons he believes that inflation will trend higher, he said.
He added, however, that interest rates are probably near a “cyclical peak.”
The recent, sudden surge in long-term interest rates to 16-year highs may be driven by concern over federal debt levels, he said, with the recent selloff in bonds a reflection of fears about “the viability of the U.S Treasury.” At current interest rates, he noted, the interest on the national debt will soon surpass defense spending.
Nevertheless, he contended that the current high yield on Treasurys is “a good deal [and] a good opportunity to buy TIPS,” he said.
The discussion moved to alternative assets. To what extent should they be part of a client’s portfolio nowadays?
“There is no alternative to diversification,” said Hooper. “And that means broad diversification—equities, fixed income, and alternatives.” Within those major asset classes, she recommended further diversification, she said. Clients should have positions in private credit, private equity, and “perhaps some hedge-fund exposure and commodities,” she said.
Alternatives are “an attractive diversifier,” she continued. More and more investors and advisors are recognizing their potential. She expects that clients will end up with somewhere between 10% and 30% of their portfolio in alternatives.
In response to a question about 60-40 portfolio diversification, referring to 60% equities and 40% fixed income, she acknowledged that this allocation is more attractive today than it was a few years ago, when bonds were near zero. But it’s better still to leave room for alternative assets. “I argue that a 50-30-20 or a 50-35-15 portfolio looks even more attractive,” she said.
Panel members also recommended foreign investments as another area of diversification.
“There are a lot of opportunities outside the U.S., with far more attractive valuations,” said Hooper. “Part of my mantra is, ‘diversify your income sources.’ And dividend yields elsewhere are very attractive and, in many cases, at higher levels than in the U.S.”
In addition to alts, she said, having a portion of equity and fixed income portfolios in international markets is “a very important part of getting allocations right for the future.”
Ablin agreed. One of the reasons the U.S. has come out of the pandemic lockdown so well, he said, is that we “spent our way through it.” One result is that international markets—particularly developed ones, he said—are at a “valuation discount” compared to the U.S.
Besides international equities and bonds, many currencies are relatively cheap, too, he said. “You shouldn’t be surprised that a lot of Americans are taking trips to Japan now because they can go there and live like kings and queens,” he said.
He’s less enthusiastic about emerging markets, though. While this might be a good moment to buy yens and euros, he said he’s “not inclined to double-down on emerging markets right now.”
Asked about her views on inflation around the world, Davis stressed that “Inflation is global, with the exception of the Chinese.”
This is why inflation protection is so vital, she said.
“In the real world, inflation is like a thief in the night. I don’t want to bet my life savings [on the Fed’s getting inflation down],” she said. People should own inflation-protected bonds as a key asset class, she insisted, especially as they near retirement. Not doing so “could really impact your quality of life,” she said.
