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If 60/40 Keeps Working, Democracy Has Failed, Paul McCulley Says

(Bloomberg) — Portfolios consisting of 60% equities and 40% bonds have had an incredible run, both this year and over the long term.

However, with yields on long-term Treasuries near all-time lows, the chorus of naysayers toward the so-called 60/40 portfolio has grown. The criticism is based on the very reasonable grounds that you’re not getting paid much to hold bonds and there isn’t much scope left for capital appreciation.But to understand the real risk to the 60/40 strategy, it’s first helpful to understand the dynamics that have made the portfolio such a winner all this time. The key is that in the short term, Treasuries and stocks tend to move inversely to each other. When people are bullish on risky assets, they tend to lighten up on safe-haven Treasuries. When investors are fearful and stocks are tanking, Treasuries tend to do well. This nice inverse correlation dampens volatility for the portfolio overall.

The other big reason 60/40 has done so well is that bonds have been in an incredible multidecade bull market. So while in the short term the two components balance each other out, over the long term both have gone up massively. Win-win.

According to Paul McCulley, a former managing director and chief economist at Pacific Investment Management Co. and now a faculty member at Georgetown Law, the dual bull market in bonds and stocks is the result of policies that started around 40 years ago and established, in his words, a “monetary policy dominant world” that crushed inflation at the expense of other economic priorities, such as full employment.

As McCulley explained on the latest episode of the “Odd Lots” podcast, former Federal Reserve Chairman Paul Volcker’s aggressive tightening, the Reagan-era supply-side revolution, Alan Greenspan’s monetary dominance and Ben Bernanke’s inflation targeting all succeeded wildly at depressing inflation to the benefit of financial assets.

“If the ideas that have worked over the last 40 years work going forward, then democracy has failed,” said McCulley, who is well-known in financial circles for coining phrases such as “shadow banking” and “Minsky Moment.”While he’s not calling for some immediate failure of conventional strategies, he does see them flopping fairly soon.

When Democracy Fails

“If it were to work on a secular basis for five years, 10 years, 20 years, then we have unambiguously failed as a democracy,” he said. “The reason financial markets have done well over the last 40 years is because we’ve been in a 40-year disinflationary environment.”This is the result of a political victory by those who control capital over those who provide labor, he says. “Unambiguously, we’ve had 40 years of disinflation, and that’s because we’ve shifted power in our economy, both domestically and globally, from labor to capital.”

“We’ve had a 40-year tailwind of falling real interest rates, which will by definition increase the market value of all income streams,” he said. “That’s what capitalism is all about: Ownership claims on income streams. It’s been an incredible bull run on the valuation of financial assets. And I certainly hope, as a citizen, that is not repeated.”While McCulley is no longer managing money professionally, he has a wish for the investment industry: “I really hope that my old profession figures out a new paradigm,” he said. “What’s worked the last 40 years should not work unless you want democracy to fail.”

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Of course, the consequences for financial assets if there is a reversal in inflation are well-known to Wall Street. That’s why people talk about it and debate it nonstop. Unfortunately, what economists and investors lack is a cogent theory of what actually causes it.

McCulley himself admits that the drivers of inflation are poorly understood, though he sees it is, in part, a measure of labor-market bargaining power — power that has steadily eroded over time. Now he “unambiguously” thinks this profound policy regime change is coming, and in the process it will bust up the portfolio construction strategies that worked so well in the past.

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