The last three years have seen great growth within stocks and bonds, with investors often enjoying double digit returns, but the next three years look less than certain to financial professionals, which could prove problematic for the traditional 60/40 portfolio.

After years of fairly steady growth and very healthy returns, more modest market performance could be a healthy thing, writes Mark Hackett, chief of investment research for Nationwide’s Investment Management Group, in a recent blog post.

In an environment of inflationary risk, rising interest rates, market volatility, and high valuations, this possibility has financial professionals concerned about their ability to meet clients’ needs, as found in a recent study conducted by ETF Trends on behalf of Nationwide Financial, says Hackett. The concerns are enough to have financial professionals looking for alternative potentials to traditional stocks and bonds.

“According to the ETF Trends survey, nearly eight in 10 financial professionals are comfortable with using non-traditional income strategies for their clients. About half (46%) currently use non-traditional income strategies with clients. Another 35% would consider doing so,” Hackett notes.

Valuations are currently high for equities, with the S&P 500 trading at a price/earnings ratio that is 21.4 times the estimated forward earnings over the next year. Compare that to the average over the last 25 years of 16.3 times, and the difference reflects that uncommon market environment we are experiencing. Reasons for such high valuations include low interest rates, outperformance by tech companies that often carry their indexes, and strong earnings revisions, Hackett explains.

Bonds have also experienced positive returns in the last three years, capitalizing on falling interest rates and the narrowing of credit spreads.

All of this could be shifting, though, with the potential of an interest rate hike next year by the Fed and earnings revisions slowing over recent quarters. While the yield for the Bloomberg U.S. Aggregate Bond Index is 1.7% right now, interest rate increases in the next few years would reduce the returns to about 1% annualized.

“That doesn’t provide much of a buffer to stocks in a 60/40 portfolio, especially if equity returns also moderate to the single digits. Rising inflation poses a threat to bond investors’ ability to generate adequate income and maintain the purchasing power of their returns. If rising prices prove to be more lasting than transitory and outpace interest rates, real yields on fixed income investments could turn negative,” writes Hackett.

There are opportunities for investors to find alternative avenues for returns; Hackett suggests value, small-cap, and international stocks as places to seek returns at “more reasonable valuations.” Also, as equity indexes are driven largely by the major tech giants, utilizing actively managed strategies could allow for better navigation within the equity space than the over-concentrated benchmarks.

Within bonds, Hackett recommends considering cred-sensitive bonds, dividend-focused equities, and other alternative income strategies. All of these could allow for better, more reliable returns than a traditional portfolio in a fluctuating market environment that could produce modest returns in the coming years.

For more news, information, and strategy, visit the Retirement Income Channel.