Is the ‘balanced’ 60/40 equity/bond portfolio a thing of the past?

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.