When might 60/40 portfolio returns bounce back?
27 October 2022
- Investors allocating 60% of funds in equities and 40% in bonds, so-called 60/40 strategies, have had a torrid time.
- Bonds and equities have been more correlated than their long-term norm since the beginning of the pandemic, limiting the diversification benefits of 60/40 portfolios. Their correlations have been particularly tight over the last year, a time of commodity-price shocks and multi-decade highs in inflation.
- As central banks shrink their balance sheets, and so reduce market liquidity levels, equity and bond correlations may de-link.
- Weaker quarterly earnings growth than the market expects is a distinct possibility over the rest of this year.
- Staying invested, being well diversified, and sticking to your plan still seems a sensible approach.
For investors with 60/40 portfolios, the economic fallout from the COVID-19 pandemic, energy and food price shocks, and uncomfortably high inflation levels, has created a nightmare scenario. Market reaction to the above events, as equity and bond returns huddled close together, has made it more difficult to diversify portfolios enough for 60/40 investors.
However, after the market storm, things should become brighter. Probably more so for those contemplating a broader diversification net, better able to diversify appropriately to shield portfolio returns from the effects of extreme volatility.
Diversification aims turned upside down
Historically, government bonds have had a low correlation with equities and, perhaps more importantly, provided protection during periods when equity markets struggled. But not in 2022. It is the first time in fifty years that investors have seen negative returns in the first nine months of the year for both US equities and government bonds. Of course, returns could pick up over the rest of the year, but this looks unlikely.
That said, anyone investing in an American 60/40 portfolio this year has had a shocker, with a drawdown of about 19%1. To put that in context, a typical US 60/40 portfolio has had the worst first nine months to a year this century1.
Does the future look any brighter?
Soaring inflation, combined with sharp increases in interest rates, have helped to take the shine off the appeal of bonds as a diversifier. If similar macro conditions persist over the next three months, then 60/40 portfolio returns may worsen. But this is not new in itself, and it is the size of the effect on performance that is different this time. Since central banks coordinated asset purchases to boost market liquidity, and scythed interest rates in the shadow of the global financial crisis, equity and bond correlations have narrowed.
But long-term investors have reason for optimism. After the market sell-off seen this year, market-implied expected returns over the next ten years for both equities and bonds are, on average, 2-3% higher than twelve months ago1. (Albeit forecasts are no guarantee of what will eventually play out).
What does this mean for asset allocation?
In terms of bond holdings in 60/40 portfolios, higher interest rates suggest that they may perform better. This is due to the chunkier source of income likely in such a world, while still leaving room for gains if rates reverse. As such, current rate levels seem attractive from a long-term investment perspective.
Given the falls seen in credit valuations this year, credit appears to offer more value than it did last year. However, caution is the watchword in the short term, especially for high yield and emerging market bonds. This is because the recent high levels of uncertainty are likely to last into 2023, until more clarity emerges on the likely path for interest rates, inflation, and several geopolitical flashpoints.
Turning to the long-term outlook for equities, this has also quickly improved this year, following a sharp sell-off. That said, credit – and investment grade bonds in particular – retain their appeal for now, given the persistent market uncertainty.
Strapping in for the long term
The potential change in expected returns for equities and bonds, and risk premia, should be less of a problem for diversified portfolios with a long-term investment horizon. A return to more normal pre-2008 cross-asset correlations, as central banks shrink their balance sheets and so similarly reduce market liquidity, could also be a boon for 60/40 portfolios.
Staying invested, being well diversified, and sticking to your plan still seems a sensible approach for now and in the years to come.
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