3 Trends Pressuring 60/40 Portfolios Over the Next Decade

3. Climate Transition: Expensive and Disruptive

Decarbonization will be challenging and create some uncomfortable trade-offs. Consumer wallets will feel the impact of persistently high energy prices and increased taxes, while periodic service interruptions may be the price of reducing the world's reliance on fossil fuels.

Shortcomings in government policy are likely to be exposed during a transition in which there will be unpleasant trade-offs between present and future stakeholders. Steps by policymakers to slash red tape will be controversial, while speeding financing and providing tax incentives to jumpstart the rebuilding of supply chains will be expensive.

If the war in Ukraine and sanctions against Russia continue, the U.S. will face some difficult choices between promoting domestic energy production or acquiring more oil from repressive regimes.

The next decade for markets is likely to feature lower returns, higher inflation and greater volatility. Although inflation will likely decline from current peak levels, the "new normal" is likely to be above 3%.

With inflation perhaps the greatest threat to returns and monetary policy moving from a loosening to a tightening bias, bonds may not be as consistent a hedge against falling stock market prices. In addition, with bonds still at tepid yields relative to inflation, income-focused investors may need to supplement traditional bond holdings in the search for yield.

Consequently, the oft-heard advice to "stay the course" may be inappropriate for the environment of the coming decade. Long-term investors should think about making some "course adjustments" to add investments that provide incremental diversification, inflation protection and/or incremental income:

• Diversify beyond the U.S.: U.S. stock indexes have soundly beaten most non-U.S. indexes during the past decade. The benefits historically provided by international diversification have not materialized during much of the past decade. Although non-U.S. indexes have largely lagged U.S. indexes, many of the best-performing stocks over the last decade have come from outside the U.S. At the stock level, there continue to be compelling opportunities in both developed international and emerging markets. In addition, in a more fragmented economic and trading regime, regional diversification may be more helpful than has been the case during the last decade.
• Real estate/real estate investment trusts: Core real estate provides income and potential for capital appreciation. Residential REITs may offer solid protection against inflation, with rent growth likely to outpace inflation thanks to chronic housing underbuilding and growth in household formation. Industrial REITs may also offer inflation protection as companies are shifting away from the "just-in-time" to "just-in-case" models, spurring strong demand for warehousing, fulfillment and logistics centers. However, industrial REIT valuations have appreciated considerably in recent years, so investing cautiously over time may be preferable to investing all at once. Office and retail REITs remain less attractive due to structural shifts in consumer and worker behavior.
• Infrastructure: Toll roads, airports, bridges, utilities and cell towers are among the investments that offer steady cash flows that adjust upwards over time. Infrastructure investments typically benefit from barriers to entry and offer predictable cash flows that adjust upwards over time.
• Farmland and Timberland: Farmland benefits from population growth and reduced arable land; productivity improvements improve crop yields. Farmland is a good source of income and portfolio hedge against rising food costs; demand from China and the war in Ukraine are near-term catalysts that may boost demand for U.S. crops. Timberland pricing historically has been more correlated with inflation than with capital markets. Timberland may benefit in the aftermath of a decade of underbuilding and from increased housing demand despite rising mortgage rates.
• Treasury inflation-protected securities (TIPS): TIPS are indexed to the Consumer Price Index (CPI), providing protection against rising inflation. Shorter-term TIPS may be preferable to longer-term TIPS, as oftentimes interest rate movements on longer-term TIPs can more than negate the inflation protection when rates move significantly higher.

The 60/40 portfolio is not obsolete; traditional stocks and bonds still have a vital portfolio role. However, given changes in the long-term outlook, investors may need to be more creative to achieve the returns required to meet financial goals and manage market volatility. Diversification, inflation protection and incremental income may be harder to find, but will be available to those willing to do the necessary work.