Portfolio managers who adhere to a method of asset allocation that has served them well for more than three decades may be in need of a wake-up call.

The warning comes as a number of prominent economists are arguing that a demographic sea change threatens to foster rising interest rates, reduced inequality, and stronger wage growth around the globe. This could have huge practical implications for people who manage money, potentially upending the long-standing schematic for asset allocation that sees many portfolio managers split their investments between bonds and stocks.

"Most pension funds and endowments around the world have a similar sort of way of sussing out their projected returns from bonds and from equities and then use historical correlations from bond and equities to build efficient frontiers," Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments, said in an interview with BloombergTV. "But if that data that that historical correlation matrix is based on is based on this 35-year period of declining real yields and low levels of correlation, with bonds meaningfully outperforming cash, then this is sort of challenged if that starts to go into reverse."

Such a change would upend typical portfolio management, which has seen asset managers look to the past performance of both bonds and stocks as their guide to the future. Managers usually examine historical volatility and returns to construct portfolios that smooth and maximize returns, depending on an investor's risk tolerance.

David Fuller's view

Latter portions of this article are somewhat esoteric so subscribers may prefer the 6:42min accompanying Audio featuring Toby Nangle of Columbia Treadneedle Investments on contagion in the credit markets.  He emphasises several themes that I have frequently mentioned, including timing.

The big drop in crude oil prices mostly ended in January of this year, followed by extensive ranging.  Therefore, unless oil prices fall significantly from current levels, as some people are forecasting although I think they are likely to be somewhat higher, inflation rates will pick up from their current disinflationary levels.  We could be particularly aware of this during July and August 2016, when WTI crude fell to its low of $37.75, although bond markets would anticipate the change.    

Forewarned is forearmed, so keep an eye on this Merrill Lynch Treasury 10-Yr Future Total Return Index.  It has just seen another failed upward break, similar to what occurred in 1H 2013.  That led to another typical correction but yields are even lower today.  Moreover, the next good rally in crude oil will trigger plenty of short covering in other industrial commodities. 

At some point there will be a disorderly exit from bonds as fixed interest yields surge.  Bond investors who do not wish to experience this profit erosion may prefer to anticipate it by establishing an overweight position in equities with attractive covered yields over the next several months.     

(See also: Soros Is Said to Pull $490 Million From Bill Gross Strategy)