Portfolio Outlook Is the Best Since 2010: JPMorgan's Kelly

Much of the pain felt this year by bond investors has stemmed directly from the fight against inflation — not from some type of fundamental weakness in the bond market itself, Kelly explained. It’s highly unusual, from a historical perspective, to see inflation spike so dramatically at the same time that concerns about future growth are quickly driving down stock valuations, he noted.

“We see strong reason to believe that the current spike in inflation, while more durable than many expected last year, is not going to be permanent, if only because of the demonstrated resolve of central banks when it comes to getting inflation in check,” Kelly said.

“Our optimistic long-term forecast assumes that key central bankers, such as the U.S. Federal Reserve Chair Jerome Powell, should be taken at their word, meaning they will do whatever it takes to get inflation in check,” he said.

Assuming that rapidly rising inflation is not going to become a permanent fixture of the global economy, the basic diversification assumptions underlying the 60/40 approach still hold water, Kelly explained. Plus, over the long term, stocks and bonds should indeed remain negatively correlated, and blended portfolios should also benefit from higher-and-safer income rates, he says.

‘Bonds Are Back’

Issar agreed wholeheartedly with these points, noting with enthusiasm that “bonds are back” as an income generation vehicle. Yes investors have seen the book value of bond portfolios fall this year, but they are being compensated with an opportunity to reinvest in bonds that pay yields higher than those seen for a generation, she said.

Now that policy rates have normalized, and done so swiftly, bonds no longer look like serial losers, Issar emphasized.

“Once again, bonds offer a plausible source of income as well as diversification,” she said. “Higher riskless rates also translate to improved credit return forecasts, which will help retirement investors.”

In the end, given the improvement in forward return assumptions for public markets, a “baseline” 60/40 portfolio may deliver higher forward returns than at any time in more than a decade.

On the equity side, in response to a stronger dollar, global investments may prove attractive to U.S.-based investors, while U.S. investments correspondingly could be less attractive to non-U.S. investors.

According to Issar, Kelly and Bilton, caution is still required, however, as the non-zero potential for a more permanent shift to a more positively correlated environment may limit an investor’s capacity to diversify equity risk and may increase volatility.

“As a result, increased exposure to lower volatility credit sectors and diversified alternatives may be needed to balance risk and return at the portfolio level,” Issar concluded.