“Things can’t get much worse” usually isn’t actionable investment advice, but in the case of the 60/40 portfolio structure, it’s not a stretch to say that it’s unlikely things will get much worse.
After all, the previously beloved 60% equity/40% fixed income mix suffered through one of its worst years on record in 2022 as stocks and bonds fell in unison. Not surprisingly, that prompted speculation that 60/40 may be dead and corresponding obituaries were summarily penned. On the other hand, there’s optimism that there’s still utility in this form of portfolio composition.
Some of that optimism is rooted in the notion that inflation, which doomed the fixed income market in 2022, will ease this year. Currently, bond traders are expecting three interest rate hikes in the current quarter and that the Federal Reserve will halt after that – good news for bonds and potentially 60/40.
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.
60/40 Green Shoots
As noted above, stocks and bonds declined in unison last year, dispelling the notion that fixed income provides a buffer against slack equity markets. That scenario is historically rare because equities and bonds usually aren’t highly correlated, but positive correlations between the two asset classes can work in favor of clients after yields ascend as was the case last year.
“But now that yields are a lot higher, I think bonds have become a lot more attractive, and that means when stocks do sell off, I think you’ll really see people flee back into bonds like they have in the past. So, I do expect that going forward that stock/bond correlation that pairs really nicely together, I think we’re going to see that come back,” notes Morningstar’s Jason Kephart.
There’s added good news for 60/40 in the form of more favorable equity valuations following last year’s declines. The point of this piece isn't to pile on bonds. The 60 in 60/40 is far from perfect, particularly with valuations stretched and returns being sourced from an alarmingly small number of mega-cap stocks.
“Well, stocks are a lot cheaper than they were at the start of the year, which is usually a good place to invest. Bonds’ yields are a lot more attractive, and that’s a really important thing, I think,” adds Kephart. “Because the higher the bond yields are, the less interest-rate sensitive they are. So, it’s very unlikely that bonds will have another year like they had in 2022. Rates would have to rise very significantly. I think, given how aggressively the Fed has already hiked, that doesn’t seem likely.”
60/40 Still Worth It…In Some Cases
While there are signs of life for 60/40, advisors can be judicious in how they deploy it. For example, younger demographics don’t need 40% bond exposure, even in rough market environments. Their time advantage should be leveraged to take adequate advantage of equity upside.
On the other hand, 60/40 could prove relevant again for clients looking to reduce risk or those nearing retirement.
“So, I do think if you have a medium-term time horizon, five to 10 years, 60/40 is a really good starting point. But you should definitely think about your risk tolerance. In a year like this year, you can’t stomach, or a year like 2008 when the 60/40 was down 25%, that’s when you really need to think about maybe this is too much risk for you,” concludes Kephart.