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The 60/40 portfolio allocation is done, it's now 70/20/5 - WisdomTree

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(Kitco News) - While the current inflation threat is expected to be transitory, investors need to get comfortable with higher price pressure and need to adjust the traditional 60/40 portfolio allocation and include real assets like gold, according to one fixed income strategist.

In a recent interview with Kitco News, Kevin Flanagan, head of fixed income at WisdomTree, said that he doesn't think current inflation above 5% is sustainable in the long-term; however, he added that inflation is not going back down to pre-pandemic levels below 2%.

Long-term, Flanagan said that he sees a reasonable case for inflation to hover around 3% or 4%. He added that the sheer amount of stimulus the central bank and the federal government has pumped into the economy will lead to higher long-term inflation.

With inflation expected to remain above pre-pandemic levels, Flanagan said that it is only natural to expect the Federal Reserve to eventually tighten its ultra-accommodative monetary policies and taper its monthly bond-purchase program. However, he added that the Fed's tightening needs to be seen in a broader historical context.

"They're buying $120 billion in assets a month so would the economy really notice If they drop that to $80 billion a month," he said. "If you look back at QE during the 2008 financial crisis, at the peak, they were spending $85 billion. If the Fed were taper now they would just bring QE back to where it was less than 10 years ago."

With inflation expected to push higher and monetary policy expected to tighten, WisdomTree is expecting U.S. 10-year bond yields to push back to 2% by the end of the year.

Flanagan added that he sees the current rally in bonds, that has driven 10-year yields back down to the lows seen at the start, as a technical correction from a market that was oversold.

However, the fundamental issue is that even if bond yields do go back up to 2%, investors are still losing money when they include inflation. This is why Flanagan said that investors have to be a little more creative when they search for yield in the marketplace.

He added that the traditional 60/40 allocation is no longer a viable strategy.

"Our breakdown would be 70% equity, 20% fixed income, 5% alternative assets," he said. "I think in the environment we're in -- and probably, quite frankly for the foreseeable future -- that's the shift."

Flanagan added that in the inflationary environment WisdomTree expects, commodities like gold and real estate are attractive alternative assets.

Looking at the fixed income market, Flanagan said that there is still value if investors know where too look. He added that his firm sees value in emerging market corporate debt. He added that they see risk in holding long-term bonds.

"Our focus has been more on the reduced duration," he added. "With the Fed holding interest rates at zero, you will need to take a little bit more fixed when you search for yield. We think duration is the biggest risk you should avoid. Our approach at WisdomTree is that we're trying to search for yield, not reach for yield. And I think that's a very important distinction to make in this environment."

Turning back to monetary policy, Flanagan said that he expects the Federal Reserve will use annual Jackson Hole summit to announce their tapering plans and prepare markets for tighter monetary policy.

Flanagan added that investors should prepare for the U.S. central bank to move at a snail's pace during this transition.

"They have not taken the punch bowl away just yet but markets might want to sip in moderation going forward," he said.

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