The big increase in the U.S. M1 money supply could lead to inflationary pressures that will increase risks for the fixed-income portion of a 60-40 portfolio allocation.
April 8, 2021
By Jeff Benjamin
Traditional portfolio diversification, the bedrock of financial planning, is coming under assault from an unprecedented Federal Reserve monetary policy that is pouring trillions of dollars into circulation.
While some advisers cling to traditional models showing the long-term advantages of diversification across multiple asset classes, including stocks and bonds, the new money supply reality is raising concerns that fixed income might be riskier than ever, throwing a wrench into traditionally balanced portfolios of 60% stocks and 40% bonds.
“The 60-40 portfolio has been a great strategy over the years, depending on how far back you go, but the game-changer is that the M1 money supply just went from $6 trillion to $18 trillion in 12 months,” said Mike Willis, founder and lead portfolio manager of Index Funds.
“The Fed, by pumping trillions into the system, just made obsolete any investment strategy that holds bonds,” he added. “They just devalued the dollar in a way that a lot of Main Street investors and advisers are not aware of yet.”
To be fair, warnings that the sky is falling in the bond market have been a steady drumbeat in certain corners of financial services for decades. But there is no denying the math that the M1 money supply, which represents the total value of money available in the economy, has more than doubled over the past year.
Willis believes the early indicators of hyperinflation are already here and will only get worse as the government’s Consumer Price Index data catch up over the next 12 months, which is dire news for cash and bonds paying dollar-denominated income.
“Houses, art, collectibles and Bitcoin are all going through the roof because people realize cash is trash,” said Willis, who cited as an example the sale of a Tom Brady rookie card for a record $2.25 million less than a month after a similar card featuring the seven-time Super Bowl champ sold for $1.32 million.
“The macro shift is happening right now at this minute that advisers will have to adjust to,” he added. “They can’t just turn a blind eye to M1 money supply diluting the market.”
Bonds and cash will likely suffer the most from the inflationary cycle that could follow the money supply saturation, but some advisers are holding fast to old models.
“If a target allocation of 60% equities and 40% bonds makes sense over the long run, you shouldn’t veer from the course,” said Marisa Bradbury, investment adviser at Sigma Investment Counselors.
“However, given the current fixed-income environment, you might want to be somewhat strategic investing within bonds,” Bradbury said.
Jon Ulin, managing principal of Ulin & Co., is also not a fan of “greatly deviating from one’s portfolio risk tolerance based on current headlines.”
“We are staying the course in our clients’ strategic model-based approach to investing, especially for those in or nearing retirement with moderate to moderate-conservative risk parameters,” he added. “Moving someone to all cash, more stocks or a great amount of insurance and alternative investments is not what disciplined fiduciary advisers are paid to do.”
It is difficult to dispute the benefits of a balanced portfolio when relying on historical performance, which is what most advisers are working with.
A simple illustration by The Vanguard Group last year showed the historical risk/return profiles of various stock-bond allocations between 1926 and 2019, enabling investors to pick their poison.
On one end, the all-bond portfolio produced a 6% average annual return and suffered 19 negative years over the 94-year period. The best year for the all-bond strategy was a gain of 45.5% in 1982, and the worst year was a loss of 8.1% in 1969.
On the other end of the spectrum, the all-stock portfolio had an average annual return of 10.2%, with 25 negative years over that period. The best year for all-stocks was a 54.2% gain in 1933, and the worst year was a loss of 43.1% in 1931.
The average annual performance increases in stride with the increase in the equity weighting.
The 60-40 portfolio produced an average annual return of 9%, including 22 negative years. The best year was a gain of 36.7% in 1933, and the worst year was a loss of 26.6% in 1931.
“The basic 60-40 portfolio has been pretty unassailable for a long time, especially over the past couple of decades,” said Amy Arnott, portfolio strategist at Morningstar.
Arnott, who has studied portfolio diversification against multiple market cycles, believes the extended and seemingly resilient bull market for stocks has “people lulled into a false sense of security.”
“Even though large-cap stocks were hit pretty hard in the Covid downturn early last year, they also bounced back quickly, so it’s easy to conclude any correction will be short-lived,” she said.
That general attitude, while associated with equities, might be amplified regarding bonds, which are already generally viewed as the safer asset class.
While Willis believes equities are a safer place right now than bonds or cash, he argues that the S&P 500 Index’s 50% rise from its March 2020 low was mostly the result of the increased money supply by the Fed.
“This rise in the S&P 500 isn’t a rally based on company fundamentals, this rally is the result of the devaluing of the dollar,” he said. “There’s so much cash in the market that everyone is loaded even though they’re poor. That’s the kind of stuff you see down in Venezuela and Brazil when inflation gets out of control.”