17 APR, 2023
Julie Dickson, Investment Director at Capital Group
The classic 60/40 split between equities and fixed income has been a mainstay of balanced portfolios ever since the concept was invented by economist Harry Markowitz in 1952. The rationale behind this concept of balance was simple – to seek to provide investment returns while assuming a lower level of risk compared to a pure equity portfolio. In theory, the bond sleeve would offset the volatility of its equity brethren when equity markets were finding it tough.
Understandably questions are now being asked of this traditional investment approach following a dismal 2022 where global equity markets recorded sharp declines. This acute decline followed a post-GFC (global financial crisis) era of low inflation, low interest rates and multiple rounds of quantitative easing. 2022 saw the reversal of these factors. High inflation and higher interest rates took centre stage instead, triggering a correlation between equities and fixed income to the highest levels seen in over 20 years.
We are faced with an uncertain marketplace with changeability surrounding central bank policy responses, the slowing of the global economy, an ongoing war in Ukraine, and the change in market leadership from growth to value stocks. For the investor with a more conservative risk profile, seeking investment solutions that may balance long-term growth of capital, conservation of principal and current income is a very sensible option. We believe 60/40 portfolios offer that option and investors should not overlook their long-term credentials because of a single bad year.
Hypothetically analysing 60/40 portfolios, we found that calendar years of negative results are typically followed by calendar years of strong positive results, thereby reaffirming our belief that investors should consider, rather than be unduly concerned about 60/40 portfolios. While the investment environment and external influences driving portfolio results can vary greatly from one year to another, there are three important factors we believe could potentially drive 60/40 portfolios to do better in 2023 and beyond.
If inflation, which has been so high recently, falls again, the correlations between international equities and international bonds could return to normal. After all, high inflation is often accompanied by a close correlation between equities and bonds. One explanation for this could be that when inflation rises, inflation expectations also become more uncertain. Bonds might then command higher risk premiums, causing their prices to fall. However, high inflation and high bond yields also lead to higher discount factors for future corporate profits, which in turn hurts share prices. However, the different development of stocks and bonds is an important prerequisite for the success of the 60/40 concept.
However, positive signals are now coming from the USA again: Inflation has already fallen there and the Fed raised the key interest rate by only 50 basis points at its meeting in December 2022. This follows four hikes of 75 basis points. If inflation continues to fall, the Fed will probably slow down the rate hikes further. Quality bonds could then be more stable and offer higher yields. But lower inflation would also be good for equities, as profit margins rise as the cost of capital falls. And sales could then also increase. Corporate profits would also rise more strongly again, albeit presumably with large differences between the individual sectors.
Recessions are painful. But they are necessary to clean out the excesses of prior growth periods, especially the more or less uninterrupted growth investors have enjoyed over the past decade. Another potential bright spot is that recessions do not historically last very long.
Our analysis of 11 US cycles since 1950 shows that recessions have ranged from two to 18 months, with the average lasting about 10 months. In addition, stock markets usually start to recover before a recession ends. Stocks have already led the economy on the way down in this cycle, with nearly all major equity markets entering bear market territory by mid-2022. And if history is a guide, they could rebound about six months before the economy does.
High inflation and interest rate hikes could also drive higher bond yields in the future. When bond prices fell, yields rose in all sectors and so did subsequent returns. The total return on a bond is the sum of the change in price and the much higher yield now. Because bonds are offering yield again, the asset class is becoming interesting again. Overall higher yields mean that investors have the potential to earn more income from bonds. This could also provide more of a cushion for total returns, even if price movements remain volatile. For an active manager, this market presents compelling opportunities to find value, though selectivity remains a crucial factor.
Income could also become more important again for equities. With the market’s leadership shift last year, from growth stocks to value stocks, dividends are playing a more important role again. In the 2010s, they accounted for only 16 percent of the total return of the S&P 500 Index. But over the long term, they averaged 38 percent, and during the high-inflation period in the 1970s, they averaged more than 70 percent. The revaluation of many traditional growth sectors, such as software, social media, digital payments and semiconductors, could also provide opportunities for single stock investors. For good returns, they need to find companies that can cope with the new environment – with higher interest rates, tighter capital, changing supply chains and higher labor costs.
Maintaining a balanced portfolio makes sense in any environment, but particularly this one. Though the world has changed dramatically, investors should not be discouraged. For selective investors, change creates opportunity.