The Pandemic Has Upended Asset Allocation Rules

Asset allocation, like morals or diet, is a sphere where simple edicts often help guide better decision-making.

The goal is to rent out money at the best yield possible while still getting repaid. Pre-pandemic, my starting point was to hold a mix of global stocks, long-duration Treasuries and real estate in roughly equal amounts. This allocation assumed stocks, bonds and real estate would outperform cash over time, that bonds would provide portfolio protection in an economic downturn, and that real estate would be a decent inflation hedge.

But a crisis changes things. The Federal Reserve has cut interest rates to near zero and started purchasing more bonds and other financial assets such as exchange-traded funds — moves that may help prevent an economic depression in the U.S. but which also upend some of my basic assumptions. As a result, just like rules change in war, I am adjusting my asset allocation rules.

Today’s zero cash rates and historically rich bond valuations have the following implications:

They boost the risk of deflation to any asset allocation. Typically, cash is a bad investment because assets must, in aggregate, provide a return in excess of cash to incentivize investment. Once nominal cash rates are zero, however, slower inflation will raise real cash rates. Higher real cash rates will pull money out of risky assets, meaning cash could outperform.  

They change the characteristics of Treasury bonds. Long-term Treasuries provide a modest yield and help a portfolio in a downturn. When the economy softens, yields fall and bond prices rise. The amount that prices rise roughly equals the change in yield multiplied by the bond’s duration. But if bond yields are already close to zero, yields can’t fall that much further, so prices can’t rise that much. It’s like an insurance policy with a capped payout.

They boost the attractiveness of any asset with reliable cash flow, which helps explain the rise of the so-called FAANG technology companies. Judging whether stocks are cheap or expensive is harder because the alternatives — bonds — are also expensive, and bonds are expensive because cash rates are at zero.

Of course, certain core principles haven’t changed. You still have to save money if you want to invest. It’s as important as ever to spread your bets, since any single one is unreliable. Future cash flows depend on the broader environment, and as this pandemic has shown, the environment can shift unexpectedly. It’s still critical to follow what is important but can’t be easily predicted. Going into the pandemic, this meant tracking developments like the changing relationship between the U.S. and China, the technology revolution, the rise of populism and global warming. The virus is a new addition to this list, and it moves more quickly than the others.

The pandemic also reminds us that asset allocation is more reliable than timing markets, and that there is a downside to every investment one can own. Particularly given zero rates, one needs to imagine how all investments could be hurt. For instance, I’m worried about how the surge in people working from home will impact commercial real estate, and how newly strained state budgets will impact municipal bonds.

Faced with all that’s changed, I am holding on to stocks and real estate, trying to create a substitute for government bonds and looking for ways to hedge both deflation and inflation. There are no ideal options, only trade-offs. But by holding a mix of assets that offer some protection in a down market and those that provide some yield, I can create a portfolio that is more stable.

What assets probably help in a down market?

More cash. Holding more cash now makes some sense. While this hurts my return, it is also good protection if deflation emerges and real rates — which are those after accounting for inflation — start to rise.

Gold. This is cash that someone can’t print. Like cash, it doesn’t have a yield; unlike cash, it can be a decent hedge for currency weakness or inflation.

Long-duration bonds. In the U.S., these yield above 1%. In a crisis, they could fall to close to zero. Given the way bond pricing works, this would equate to roughly a 20% return. While this has less upside than the past, 20% is still something. If inflation picks up, however, these will suffer badly.

There are also a number of assets that provide some yield, though they will all suffer price declines in a serious economic bust. These are:

High-quality corporate bonds. A corporate bond is a Treasury bond that provides extra yield, or a spread, to account for higher risks. In a period of economic stress, the yield spread widens, as it did in 2008 and earlier this year, so it doesn’t work quite as well as a regular government bond. Yet, with companies enjoying captive cash flows, the risk of default is low and the spike in spread is less a function of credit risk than of diminished liquidity, which is likely temporary.

Bank-preferred stocks. After 2008, regulations tightened such that the big U.S. banks became more like regulated utilities. While their stock prices can swing around, the preferred stocks are higher up in the capital structure and pay a dividend.

Real estate investment trusts. These pay a yield and some even have assets that are backed by government guarantee.

Infrastructure, such as pipelines. Prices are depressed, and as a result, the yields are quite high. A small portfolio weight, like a small percentage of your total assets, adds a bit of yield and probably a bit of inflation protection.

In a zero-rate world, the trade-off between a return on your money and return of your money has become even more tricky. Given big moves in the stock market, it’s tempting to consider a bigger exposure. But given the long list of known unknowns, I’m sticking with spreading my bets.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Paul Podolsky is the author of "Raising a Thief." He spent more than 20 years on Wall Street, most of that time as a portfolio strategist and researcher with Bridgewater Associates.

©2020 Bloomberg L.P.

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