opinion | Financial markets: the end of the magic wallet

Does the enchanted parenthesis for the magic wallet close? 60% stocks and 40% bonds. A combination so simple and so effective that it has been offered to common savers for years. It was therefore the best compromise between return and risk. Thus was born the so-called balanced portfolio intended for the so-called normal investor.

But today something broke. The Magic Wallet is about to begin the worst start of a year in nearly 40 years. And for good reason, he ends up with his wings cut off. Equities fell nearly 10% and bonds fell nearly 5% as well. However, you can mix everything as many times as you want, you will always get a negative return. And the 60/40 portfolio is no exception to the rule with a performance of nearly -8%. The magic formula makes pschitt.

The end of the glorious 40s

However, there was a time when the investor could lean on one leg or the other to overcome cycles or crises in the best possible way. For example, if economic activity slowed sharply, the investor sold his stock and took refuge in bonds (flight to “quality”). Equity prices were falling, but bond prices were rising, limiting the negative impact of the economic downturn on the performance of the Magic Portfolio. But that time seems to be over.

To better understand the turnaround, we need to remember that our financial markets have experienced a long golden age. Specifically, it’s a glorious 40 that combines falling interest rates and rising stocks. All in a context of low inflation, but not too much. This last point is very important, indeed it is essential. Low, but not excessive, inflation was a necessary and sufficient condition for bond and equity markets to join in the fun, with the blessing of central banks.

The myth of the perfect wallet

Of course, we shouldn’t even believe it was a long, calm river. The severe crises have given the financial markets a bit of a sweat in recent years. However, the investor can always count on the zeal of monetary and fiscal policy to save the world.

It is this environment, unique in history in terms of duration and levels achieved, which has allowed the magic 60/40 portfolio to combine years of positive performance and to offer the investor a particularly attractive risk-adjusted return. All of this contributed to perpetuating the 60/40 wallet myth. So much so that a form of rational faith (Kant) developed in the magic formula. We didn’t know why it worked so well, but it was reasonable to believe …

The return of inflation

Then part of the problem changed. A figure that explains the bad past of today’s 60/40 wallet, and that raises serious doubts for his future.

What has changed and is essential is the return of inflation. A return for an indefinite period, and which continues to be extended. Inflation is then back, but this time the real thing. Not that caused by imaginary economic overheating. Inflation is back, not because of excessive demand, but because of too low supply. And the problem with too low a supply is that it could stay too low for a long time given the new world that is taking shape in Ukraine.

War in Ukraine

In a nutshell: ‘Ukraine and Russia are the main suppliers of raw materials (oil, gas, wheat …) … and some countries depend heavily on these resources … Germany for gas, but also many emerging countries for wheat ‘. And always this image of Russia, presented as a global service station, very present in geopolitics.

In this context, one could imagine that the world of tomorrow will be a bipolar world, in which each party will undertake to develop new distribution channels to benefit from the necessary resources, while limiting the geopolitical risk with the supplier. But before we get there, it is likely that we will still experience some spectacular spikes in inflation, punctuated by the evolution of the ongoing conflict.

The specter of stagflation

We will not raise the scenarios of confused futuristic economists on oil ($ 200, $ 400, $ 1000 …), on gas, on wheat. The truth is, we don’t know. On the other hand, what we do know is that these tensions would cause a strong shock to the purchasing power of households and to the margins of businesses. The reaction would have been immediate: decline in household consumption, business investments, unemployment … In the 70s and 80s it was called stagflation: galloping inflation, then steady economic growth.

Stagflation is not news today, but we are talking about it. Sure, inflation is galloping, but growth remains buoyant, still all excited by post-Covid deconfinement. However, the financial markets don’t need to see to be afraid. They just have to believe that the stagflation scenario is now part of the possibility horizon for imagining what will happen next: significant increases in interest rates combined with falls in stocks, and the 60/40 portfolio collapses on it.

Limited rate increase

However, there would be a difference between our situation and the stagflation of the 1970s and 1980s. Unfortunately, this difference is not to our advantage. In those years, investors avoided bonds and stocks, but could always take refuge in the return on money, which then reached high levels, against the backdrop of restrictive monetary policies and anti-inflation.

But today even the most aggressive American central bank is forecasting a maximum rate hike to 2% in 2022, and eventually to 2.5% … It’s even better than 0% of course. And it is much better than in the euro area where the ECB is not proposing any rate hike, even if ‘nothing is excluded’ (according to Christine Lagarde).

Karl Eychenne, researcher at Oblomov & Bartleby

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