By Brendan Ryan, CFA Partner, Portfolio Manager
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For much of 2023, investors were leery of holding traditional risk assets given the attractive prospects of riskless cash yielding over 5%, and the poor trailing performance of nearly all cash-flowing assets. While the recent decline in rates and more Dovish tone of the Federal Reserve may have eased those concerns, there are still economists and many market historians who expect inflation to re-emerge meaningfully and pose risks to asset allocated portfolios. While we would acknowledge there are certainly risks to risk assets (by definition) in the current environment, we do expect the traditional benefits of a diversified portfolio to play out from here.
Over the trailing two years, a portfolio of 60% US Stocks and 40% US Bonds have returned -8%, while sustaining a max monthly drawdown of -14.5%. This was one of the worst stretches in history for the bedrock of diversified portfolios. On average a 60/40 has been negative in just 24% of two-year spans and a double-digit decline is less than a one in ten event.
What’s most rare about the last two years is that they weren’t exclusively driven by the riskier part of the portfolio. When rates rise rapidly, all else being equal, every cash flowing asset becomes less valuable and in the recent aggressive rate hiking cycle nearly every cash flowing asset has been underwater.
 Bloomberg data using a monthly rebalance of 60% S&P 500® Index and 40% Barclays Aggregate Bond index from 12/31/1975 to 11/30/2023.
Given that investors price risky assets off a risk-free reference rate in order to generate a return above that rate, which has held true historically, only a unique set of circumstances should allow for cash to outperform for an extended period of time. As the chart shows there has been just one such period in recent history: the infamous stagflationary 1970s.
At first glance there are obvious commonalities between the last few years and the 1970s:
- An influx of monetary stimulus
- Rising commodity prices
- Rising wages
- A major supply disruption (The 1974 Oil Embargo and the 2020 Covid Lockdown)
However, the economy of the 1970s was extremely dissimilar to the one we have today. Those differences are why we believe the consistently high inflation of the 1970s was unavoidable but need not re-emerge in our modern economy.
The Role of Oil
While we saw a near 100% increase in Oil prices when Russia invaded Ukraine on top of post Covid economic re-opening, this was paltry compared to the greater than twofold increase in 1974 when Oil jumped from $3.50 to $10.00 on its way to over $14.00. There was no remedy for Oil supply shocks at this time because OPEC commanded a massive share of the oil supply market.
 Exhibit 1
Today the United States is the largest oil producing country on the planet, producing at a rate equal to our consumption. Oil was incredibly important as an input to our economy when Manufacturing and Goods were dominant versus today where Services dominate our economy.
In 1974, an external supply restriction of a key input to the economy (oil) shrunk economic potential on top of higher input prices which created the conditions necessary for stagflation. Normally when the economy shrinks companies need fewer employees and unemployment rises. In turn, employees often command a lower wage (at least after inflation – a low “real” wage) in a bad economy with higher unemployment which ultimately allows companies to hire more of them, and the initial rise in unemployment slowly abates. However, wages tend to be “sticky”, and don’t adjust quickly. As the economy shrank and prices rose very suddenly in the early 1970s, wages (especially after inflation – real wages) did not adjust appropriately low enough to improve unemployment thus creating the final piece of the stagflation puzzle – high unemployment alongside high inflation.
As further evidence of the outsized role of oil, estimated by some economists to have reduced manufacturing output by 60% during the 1970s, inflation actually had fallen to just 5.06% by November 1976—roughly 3 years after the embargo. Inflation only subsequently rose again as oil itself rose again due to the Iranian revolution in 1978 which again restricted global oil supply.
As our current environment has no such forced supply constraints, we expect free market economics should continue to work. High prices incentivize more supply which in turn reduces prices, while low prices incentivize less supply and in turn leads to higher prices.
While we are likely to experience a period of higher inflation and interest rates than we have become accustomed to in the zero-interest rate period preceding COVID, there is no reason to abandon basic investing principles including seeking a diversified portfolio to weather the storm and meet a financial plan no matter what lies ahead.
Exhibit 1. Historical Asset Class Returns in Excess of Cash
 Bruno, Michael and Sachs, Jeffrey D., Supply vs. Demand Approaches to the Problem of Stagflation (August 1979). NBER Working Paper No. w0382, Available at SSRN: https://ssrn.com/abstract=261235
 CPI for urban consumers yoy, retrieved on Bloomberg
Exhibit 2. 1970s CPI YoY
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The Standard & Poor’s (S&P) 500® Index is an unmanaged index that tracks the performance of 500 widely held, large-capitalization U.S. stocks. The MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries. With 1,392 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI EAFE Index is an equity index which captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. With 876 constituents, the index covers approximately 85% of the free float adjusted market capitalization in each country. The Bloomberg Aggregate Bond index is designed to represent the full range of investment-grade bonds traded in the U.S. It is composed of more than 10,000 issues. U.S. Treasuries represent nearly 40% of the index. The remaining components represent the debt of major industries including real estate, industrial companies, financial institutions, and utilities.
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