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With bonds and stocks languishing this years, frustration with 60/40 portfolio construction is understandable and palpable.
How bad are things for 60/40 in 2022? As of July 8, this year is shaping up to be one of the three worst years since 1976 for what was once the gold standard of portfolio construction. As of that date, 60/40, as measured by the S&P 500 and the Bloomberg U.S. Aggregate Bond Index, was lower by almost 15%. On an annual basis, the only year that was more dismal was 2008 – the height of the global financial crisis – when 60/40 shed 20.1%.
The 60/40 outlook wasn't always this dire. There was a significant stretch of time when bond investing was almost “easy.” When President Reagan took office, the Federal Reserve's benchmark lending late was a staggering 21.5%. Today, it's close to zero, meaning for about four decades, the 40 in 60/40 was a boon for investors.
Obviously, market environments change and this year, the rising interest rates and persistent inflation are seeing to that. Still, some debate remains regarding the purported death of 60/40.
Maybe Some Hope for 60/40. Maybe.
History suggests that when 60/40 falters, this year and 2008 being obvious exceptions, the declines are usually tolerable.
“In basically one out of five years, 60/40 has delivered negative calendar year returns. This is also the same frequency that stocks have delivered a negative calendar year return, but they don’t always overlap,” opines Bradley Krom, WisdomTree head of U.S. research. “I suspect the reason we’ve seen so many articles bemoaning the shortcomings of 60/40 is that 2022 has seen some of the worst absolute returns for 60/40 since the inception of the Agg. In fact, only 2008 delivered a worse performance. However, as we show in the table below, negative returns for 60/40 tend to be manageable, particularly when fixed income returns are positive. “
Not surprisingly, inflation is also a drag on 60/40 portfolios and that scenario isn't going to get easier. If forecasts are accurate, the Consumer Price Index (CPI) won't decline in earnest until early next years…if we’re lucky. Here's why 60/40 is vulnerable when inflation is high: Essentially everything in an aggregate bond fund ends up with negative real yields.
However, as Krom points out, 2022 is shaping up to be very much an exception to the 60/40 rule and while that’s near-term painful, it could eventually prove to be a long-term positive.
“So why is 2022 such an anomaly? Well, this is the first year when both stocks and bonds have been down in tandem (and unfortunately both are down around 10%),” he notes. “This gets back to the fundamental reason why people have allocated to 60/40 historically: low correlation between equities and fixed income. With interest rates low, the possibility of negative total returns increases. Should equities fall at the same time, correlations go positive when both markets are selling off.”
Rates Matter
Obviously, rising interest rates are punishing both sides of 60/40 and with more rate hikes on the way, investors are understandably skittish about bonds.
Believe it or not, some experts say it’s possible rate cuts could arrive next year, particularly if a recession sets in. That could breathe some life into 60/40 after what’s shaping up to be two consecutive annual declines for aggregate bond strategies.
“While U.S. rates have backed off of the highs of May, we do have precedent for back-to-back calendar year losses,” concludes Krom. “However, with rates at significantly higher levels than they started the year, it seems very unlikely that fixed income will be able to generate significant returns through the end of the year. But with the market actually starting to price in rate CUTS in 2023, it seems reasonable to expect that fixed income returns will be much less of a headwind in 2023 than they have been in 2022.”