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Is the ‘balanced’ 60/40 equity/bond portfolio a thing of the past?
Peter Siks
Oversigt: For years, it was thought that the balanced portfolio was a thing of the past. But recent developments may have changed that.
The 2022 investment year was an extraordinary one as both stocks and bonds went down hard, an unusual combination for the modern investor. In fact, the traditional ‘balanced’ portfolio of 60 percent stocks and 40 percent bonds saw the worst nominal performance in memory, at least since 1871 according to an FT article. The idea of the 60/40 portfolio is based on the assumption that growth rewards the stocks in the portfolio, while the bond portion performs a kind of income-generating buffer function and diversifier in downturns, due to recent years in which bonds were most often negatively correlated with stocks. The return over the last 40 years for the 60/40 portfolio has been about 7.5 percent per year with a volatility of 8.9 percent (by comparison, the volatility for the MSCI World equity index was 15 percent). But with the disastrous investment year 2022, can we argue that the 60/40 portfolio should be a thing of the past?
Just back in time
The outlook for the 60/40 portfolio was not strong in 2020 and 2021. Interest rates were extremely low globally and stocks were extremely expensive by almost any measure. The expected return on bonds (a mix of corporate and government bonds) was slightly above 1 percent, while the earnings yield in equities was a mere 3.5 percent. As the earnings yield is the inverse of the P/E ratio, an earnings yield of 3.3 percent, for example, requires a P/E ratio of 30.
Many analysts did warn of poor outcomes for equities on interest rate sensitivity at the time, noting that only ever lower interest rates (difficult when trillions in global bonds were trading at negative nominal yields) could support equity valuations, much less drive them higher still. With yields rising in 2022, the ‘valuation reality check’ was on the loose to reverse some of the massive equity market gains of 2020 and 2021. This, rather than any recessionary dynamic, which is the normal driver of bear markets (and bond market strength).
But really, equity markets have been supported and valuations have risen in a secular move for most of the last 40 years by falling interest rates, even if shorter term cycles saw negative bond/equity correlations.
Will the 60/40 portfolio make a comeback in the near term?
There is no question that the 60/40 portfolio had a near-death experience last year. But with much higher interest rates now and after a bear market in stock prices has been established, the starting points for a traditional 60/40 portfolio are a lot brighter than they were two years ago. A global basket of bonds yields around 3.5 percent (global aggregate in USD) and the earnings yield of the MSCI World is currently around 5 percent.
Expected return
So what is the expected return of a 60/40 equity/bond portfolio? For bonds, the expected return can simply use the current return. For the equity portion, we can plug in the assumption of the historical average EPS growth rate of about 6 percent per year for the MSCI World. A part of the expected return is also the dividend yield, which has been about 2.5 percent over the last few years prior to the pandemic.
Points for consideration
It’s critical to know that expected return is no guarantee, and several factors require careful consideration for investment return prospects:
- Will inflation continue to fall? This will have a bearing on interest rates, which will likely need to stabilise and even fall to achieve attractive returns this year. The market is currently assuming two more 0.25 percent rate hikes by the Fed and then a period of calm, with forward yields priced to drop next year. Given the unresolved underlying issues that are inflationary, this positive scenario is unlikely to materialise. A few issues: deglobalisation, the green transformation and too little investment in the real economy, such as in infrastructure and the extraction of commodities. Inflation is more likely to bottom around 3 to 4 percent rather than the 2.25 percent currently expected by the market. As a result, substantially falling interest rates will take longer than the market is now pricing in.
- How realistic are expectations of EPS growth? These expectations, while slightly lower in recent months, are still positive. The question is whether companies will be able to maintain margins – given inflation and weaker economic growth – and thus maintain profits. An actual recession in the US and Europe would be very negative for EPS. However, our expectation is that the likelihood of a recession in the US is low. A very strong labour market and the financial health of the US consumer could keep the US economy in better-than-expected shape this year.
- The traditional negative correlation between stocks and bonds might just become less negative (or even positive). A negative correlation means that if one asset class goes up, the other will go down. With a positive correlation, both asset classes will move in the same direction. So a positive correlation would mean that the bond portion of the portfolio loses its dampening effect. And this does not impact the final return so much as it impacts the volatility of the return because the volatility of a 60/40 portfolio will increase with a positive correlation.
Constructing a 60/40 portfolio
Because of the flat (or inverse) yield curve, the bond portion of the portfolio can be partially filled with short-term bonds. To illustrate: short-term US paper yields well above 4 percent. This dampens the portfolio's interest rate sensitivity. To slightly increase the potential return, a portion could also be invested in corporate bonds where the yield is about 5 percent. For the equity component, considerable diversification can be achieved with the MSCI World index. Of course, this can also be filled in with more specific choices within global sectors. Research shows that in an inflationary environment, opting for 'real assets' such as real estate, infrastructure and commodities improves returns.
Conclusion
Despite the disastrous year 2022, the 60/40 portfolio is not dead. This is because the expected returns for both stocks and bonds have improved substantially. Stocks are less expensive than they were about two years ago, and bonds are returning to positive nominal returns at worst (and even positive real returns if inflation continues to drop this year). Of course, the determining factors remain corporate earnings growth and central bank interest rate policy. We assume that the reopening of China will contribute to the profitability of companies worldwide. As well, it is also Saxo's view that the US will experience no – or a very shallow – recession. In addition, inflation will stabilise at slightly higher levels than the current consensus, yet this will have a limited upward effect on interest rates.