The old 60/40 safety net will fail if the next market shock is global inflation

The old 60/40 portfolio can break badly if the next market shock comes from global inflation. That is the ugly part investors are being forced to deal with now.

Bonds are expected to form the conservative side of any investment portfolio. Bonds offer stable returns, minimize volatility, and act as an insurance against falling equities and investor risks. These characteristics made the most sense under conditions other than those of inflation.

According to Morgan Stanley (NYSE: MS), analyzing nearly 150 years of bond and equity data showed significant issues with this approach. As it turned out, bonds become less of a safe asset when inflation is persistently elevated.

The conventional ratio of 60% of stocks to 40% of bonds relies on a single assumption, namely, stocks try to achieve positive long-term returns, whereas bonds are used to minimize negative fluctuations. The validity of this assumption started to be questioned following the equity market peak of late 2021.

Inflation makes bonds act less like protection when stocks fall

The S&P 500 Total Return Index has climbed far above its early-2022 level. The classic 60/40 portfolio also recovered, but it has not kept up with stocks. The Bloomberg Aggregate Bond Index, which tracks a wide basket of high-quality U.S. bonds, has only fought its way back to around where it stood at the start of that period.

This provides a rather sanguine picture of the bond market. Bonds have been lagging for many months, and the charted index peaked well prior to this chart period and hasn’t even come close to making up those losses. This lag in long-term bonds has resulted from their greater sensitivity to interest rate increases.

This shouldn’t be misinterpreted as bonds being of no use. Bonds generate income, which is now more attractive due to higher yields than it would have been otherwise. The true problem for the investor is determining whether bonds will serve their purpose when the next shock hits the stock market.

Bonds might provide the usual service when the market is facing shocks resulting from weak growth or recession fears. As yield decreases, bonds will increase in value, and this could provide protection from further declines in stock prices. However, if the shock is from inflation, oil prices, deficits, or an interest-rate scare, bonds might only provide income.

This is part of what makes the classic 60/40 allocation look less secure than it did previously. This allocation model was based on the fact that stocks and bonds had complementary movements. Stocks declined when inflation increased, while bonds rose, providing protection to the investment portfolio. However, now, inflation can damage both investments at the same time.

Oil, Treasury yields, and crypto liquidations hit traders at the same time

Last week showed how fast pressure can spread through the market. Stock bulls took control again after a brief scare, and the S&P 500 pushed back near another record high. The index has now gained for eight straight weeks since its March 30 bottom during the Iran war period. That is its longest weekly winning run since late 2023, when it rose for nine straight weeks.

By Friday, the S&P 500 was less than 0.4% below its May 14 record close of 7,501. That looked very different from the start of the week. Oil was back above $100 a barrel, and the 30-year Treasury yield hit its highest level since 2007 on Tuesday. Stocks did not take that calmly. The S&P 500 ended Tuesday with a three-day losing run that began on May 15, its first such run since March 26, 27, and 30.

On Saturday, Bitcoin (BTC) fell under the $75,000 mark after weeks of ETF withdrawals. At one point, the asset touched the price of $74,344, which marked the lowest point since last month, before moving higher toward the mid-$75,000. This comes as less than a week after BTC was trading above $80,000.

Ethereum (ETH) is currently trading near $2,060 after losing over 2% in 24 hours. SOL is trading near $84 after posting a larger daily decline.

The derivatives sector was among the most affected areas, with total crypto liquidations hitting a 24-hour high of $917 million. Bitcoin posted losses of $371 million, while Ethereum accounted for around $261 million in losses. The bulk of this number ($827 million) represented long positions that were washed out because BTC had dropped below $75,000.

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