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The 60/40 portfolio structure, which has long been considered THE standard in asset allocation among registered investment advisors, took a well-documented tumble last year. That’ll happen when stocks and bonds enter bear markets in unison – the exact scenario that spells doom for 60/40.
Not surprisingly, 2022 woes for 60/40 stirred chatter about its foundation and relevance in a new investing regime. Indeed, 60/40 or slight variations thereof isn’t for everyone. A 40% fixed income allocation is arguably far too high for a 35-year-old client. Likewise, a 60% tilt to stocks could be too aggressive for clients in their 70s.
Still, prior to last year, historical returns suggested 60/40 was effective and while past performance isn’t a guarantee of future returns, history could provide a platform for a 60/40 resurgence. Some of that optimism is rooted in the notion that inflation, which doomed the fixed income market in 2022, will ease materially in 2024.
Interestingly, elevated Treasury yields – a byproduct of the interest rate hikes used to damp inflation – could hold the key to renewed long-term success for 60/40.
Reading Bond Tea Leaves
One of the primary reasons why 60/40 worked so well, broadly speaking for more than four decades was because interest rates mostly decline from the early 1980s through the start of the current decade. Ensuing declines in Treasury yields pave the way for fixed income upside without the need for elevated risk in the “40” sleeve.
Obviously, interest rates aren’t as high today as they were in the early 1980s, but it’s possible that a similar decline plays out over time, which could renew faith in the 60/40 structure.
“While ten year U.S. Treasuries are projected to be at 5.8%, up quite significantly from 4.7% in 2022,” notes Morgan Stanley’s Serena Tang. “But the steeper climb in nominal long run expected returns for government bonds is also eroded risk premiums, that is the investment returns assets are expected to yield over and above risk free assets. For example, the equity risk premium for U.S. stocks sits at around 3.8%, down from 4.9% just a year ago.”
Point is, the higher a bond’s yield is when an investor gets involved, the shorter the odds are of success. Plus, relative to equities, bonds are attractively valued today.
“In fact, looking across assets, fixed income stands as being particularly cheap to equities relative to history. European and Japanese equities screen cheap to most other assets on an FX-hedged basis, and Euro-denominated assets look cheap to dollar denominated assets,” adds Tang. “Furthermore, our estimated optimal allocation to agency mortgage backed securities has increased at the expense of investment grade credit over the past year, reflecting how cheap mortgages are relative to other markets.”
Credible Hope for 60/40
Thanks to the “60”, a 60/40 portfolio is likely performing admirably this year, but there’s legitimate hope for better out of the “40” in the future. In fact, if expectations prove accurate, 60/40 could get its long-term groove back.
“Against this backdrop, a traditional 60/40 portfolio which allocates 60% to stocks and 40% to bonds and carries a moderate level of risk, looks viable once again despite its poor performance in 2022, when both stocks and bonds suffered greatly amid record inflation and aggressive interest rate hikes,” concludes Tang. “From where we sit now, the high long run expected returns across most assets mean that a traditional 60/40 equity bond dollar portfolio would see about 8% per year over the next decade. The last time it was this high was in 2013 and surely a 60/40 equity bond euro portfolio could see 7.7% per year over the next 10 years, the most elevated since 2011.”