Return of 60:40 – Smooth Terrain Ahead
February 20, 2023
After a mauling in 2022, when the balanced portfolios recorded the worst returns since 2008, the prospects for the traditional 60:40 portfolio appears reasonably bright for two reasons. First, historical trends1 show that the balanced portfolio has always rebounded after a fall. In each of the years that it declined—2002, 2008 and 2018—it rebounded strongly with 18.8%, 18.2%, and 22.4% in the subsequent year. The returns grew by -12% in 2022, indicating that should the pattern repeat, then it will be fair tidings for 60:40. The second reason is that with a recession looming on the horizon, fixed income yields are likely to go up and while equities are also predicted to see an uptick, the yield on bonds will spur the growth in the balanced portfolio model in 2023.
The Story So Far
A 60/40 portfolio, which typically allocates 60% of assets into stocks and 40% into bonds, expects one asset class to offset the other with stocks going up during high economic growth and bonds rising during volatile times. However, 2023 could be a tad different. With the battering received in 2022, both equities and bonds are at a low ebb. With Fed indicating that the cuts are likely to be moderate and expected to end by May 2023, the focus will then shift to a more liquid market. There is also an expectation that the impact of recession over the medium term will not be as severe as forecasted, with consumer spending showing signs of revival and labour market that continues to be robust. This is in contrast with the recurring news of large layoffs in the tech sector. In the rhetoric about recession, there is already a debate whether what is forthcoming is going to be a full-scale recession or a market correction, which is being called a Slowcession2 .
The net result is that corporate earnings in the US will be healthy, leading to an uptick in the equities market. Coming off from ’22 when the equities took a battering due to high valuations, the current equity valuations will be attractive enough to enter. Conversely, bond yields will continue to be high owing to a sticky inflation that Fed continues to fight. The yield on benchmark3 10-year US Treasury rates is already at 3.50%, having risen by over 320 basis points. Strategists at leading fund houses—JP Morgan, Goldman Sachs, and Vanguard, among others—are clearly pitching for the bond yields to rise even more. Consequently, a drop in equity valuations and rising bond yields are setting the stage for the return of 60:40 in 2023.
Driving Factors
Then there is the element of uncertainty. While it is too early to predict, uncertainty may be significantly lower as compared to the previous year. Most factors—Fed, Russia-Ukraine, and oil prices—while being volatile, are expected to play out their roles. The Fed tightening is expected to end by May, which makes the bond yields a lot stabler. Oil prices will also stay a lot more stable, given EU’s robust response to the Russian oil embargo threat. That said, 60:40 allocation itself will see some changes. A recent report4 released by Blackstone argues for a ‘regime change’ for the 60:40 strategy. The report recommends the traditional 60:40 allocation to shift to a 40:30:30 allocation for equities, bonds, and alternatives, respectively, to allow for diversification and higher degree of inflation protection. Even within the alternatives, the report pitches in for a 10% allocation to private credit owing to improved lending terms, higher absolute yields, and access to higher quality counterparties and eventually to better risk-adjusted returns.
In terms of the geographic spread, the US continues to be the mainstay for the 60:40 investors, with Europe still trying to deal with the on-going repercussions of the Ukraine crisis, high inflation, and, in contrast to the US market, a depressed consumer spending. At a granular level, there could be a few bright spots with the EU such as Pharma, Tech, and Energy. However, at a macro level, the sentiment could be somewhat subdued. Consequently, bond yields will remain robust in the EU region, while equities will continue to struggle owing to lower consumer spending and industrial growth.
Notwithstanding the above, it is clear that 2023 may be the best year for entry into the 60:405 balanced allocation strategy, and while it is not rare, it is also a unique moment when the correlation between the equities and debt is positive. What should be kept in mind is that 60:40, while providing a good entry point in 2023, cannot be looked at as a short term measure and needs to be looked at a much longer time frame.
