As an investment strategy, the 60/40 portfolio appeals to the so-called “balanced” investor. This appeal stems from a moderate risk appetite suited to the investor’s needs. The strategy consists of a 60% allocation to equities and 40% to bonds.
The equity portion of the strategy is typically the main driver of capital appreciation whilst the bond component provides some level of income (or yield); this portion of the portfolio is relied upon when equity markets fall. For this to work, diversification matters.
However, recent historical market events have tested this strategy – the 2008 recession and the high inflation witnessed in the 70s. Last year was another episode, now added to the history books, which tested the reliability of the 60/40 strategy.
Expected return/volatility ratio for 60/40 portfolio
The red boxes shows where we were (high bond volatility of 14 – 16); we are currently in the light green box (with volatility between 10 and 12) and expect to be in the dark green box once yields peak and bond values rise (bond volatility between 6 and 8)
Diversification is a crucial element in managing risk and achieving returns in investment strategies. What is also true is changing investor sentiment eventually leads to a market rebound, a resurgence of 60/40 and its diversification benefits.
While recent market turbulence has led to speculations about the strategy’s demise, it is important for investors to maintain consistency and adhere to a long-term plan. By avoiding panic-driven decisions during periods of market volatility, investors can ride out the storm and capitalise on the eventual market rebound, thereby benefiting from the resilience and diversification advantages of the 60/40 portfolio.
The year 2022 witnessed the 60/40 strategy underperform, resulting in a loss of approximately 17% for investors. This performance sparked discussions regarding the effectiveness of the strategy. However, the inclusion of both equities and bonds in the portfolio helps strike an appropriate risk balance. Historically, bonds have tended to hold up well during recessions, compensating for the weaker performance of equities.
Although there are rare instances when this correlation does not hold, such as the previous year, it is generally a reliable feature of the 60/40 strategy. Thus, investors should not dismiss the strategy based solely on short-term performance, as its inherent diversification benefits remain valuable for long-term investment objectives.
Inflation rules
In the past two years, inflation has taken centre stage in market discussions, which comes as no surprise. After a prolonged period of low inflation, the sudden shift caught markets off guard, challenging the long-held belief in its stability. Central banks initially found themselves unprepared, prompting them to respond with aggressive rate hikes in an attempt to rein in the inflationary pressures. However, these swift adjustments posed difficulties for investors and markets alike, as they struggled to keep pace with the rapidly changing interest rate landscape.
Amidst this backdrop, the market found itself grappling with the challenge of navigating uncertain terrain. The conventional wisdom of low inflation was abruptly disrupted, leading to a struggle for market participants to adjust their expectations and determine the appropriate course of action. As central banks deployed measures to combat inflation, the resulting rate increases created a sense of disarray, leaving investors uncertain about the future trajectory of interest rates. Moreover, the mini banking crisis that unfolded in March served as an additional blow, casting a shadow of doubt over investor sentiment. Consequently, even well-established strategies like the 60/40 approach faced difficulties and were put to the test in this dynamic and unpredictable environment.
US Inflation
In June 2023, the Federal Reserve (Fed) appeared to have paused its aggressive monetary policy tightening, marking a notable break since it began raising rates in March 2022. That first quarter percentage point hike signalled the end of a long period of loose monetary policy that followed the 2008 financial crisis and the onset of the global pandemic. The Fed’s commitment to combatting inflation has been evident, despite scepticism from the markets, as it followed through on its promise to take decisive action.
However, striking a delicate balance between curbing inflation and avoiding an economic downturn has been challenging, as demonstrated by the recent mini banking crisis triggered in March. Additionally, external factors such as the Russian invasion of Ukraine and resulting higher energy prices have further complicated the inflationary landscape. The cumulative impact of various economic shocks, including ongoing supply chain issues and robust consumer demand, has placed significant pressure on both bonds and equities, adversely affecting their performance.
UK Base rate
The UK inflation story is the other side of the coin. The Bank of England (BoE) has so far played catch up in the inflation battle. In July 2022, the base rate stood at 1.25%. The following month the BoE raised rates by 50 bps, the highest rise in over 25 years at the time. UK inflation is currently at 8.7%, similar to where the US was just over a year ago.
Policy makers in the UK have raised rates 13 times since the end of 2021 but it appears the rates of increases haven’t convinced markets about the BoE’s resolve to tame inflation. Its second 50bps rise was delivered recently and now the base rate in the UK sits at 5%. Could it go further and are markets paying any attention? It is worth noting that the UK is a couple of months behind the US economy in terms of the direction of travel in interest rates.
The return of 60/40: Fire and Ice
Bond markets are experiencing volatility as investors speculate on the end of the tightening cycle, while equity markets have remained stable in 2023 largely due to companies passing on higher prices to customers. However, bond markets are now anticipating a 50% increase in rates by the Fed, leading to a shift in market sentiment.
At the start of the year, expectations were for inflation to reach 2.8% by July 2023, with rates peaking at 3% followed by a reduction due to an impending recession. However, current market expectations indicate rates peaking at 5%.
Over the last quarter we believed the risk of recession had increased and our rebalancing decision has meant we increased our active fund allocation which would benefit from a significant economic shock and a shift in Fed policy. We had taken the view that markets were too optimistic about how quickly rates would come down.
Our approach is guided by the “Fire and Ice” framework, suggested by the ManGLG group, which sets out market conditions that affect the correlation between equities and bonds, identified by four stages in the economic cycle, emphasising the importance of inflation. The stages in the Fire and Ice framework shows how the direction of inflation drives the market cycle and how this plays into the policy making decisions of central banks.
Understanding our position in the cycle enables us to better align our investment strategies and navigate financial markets.
The Fire and Ice framework
The volatility of government bond markets is expected to decrease given that even if the Fed raises rates later this month, it would be close to where they expect their base rate to be, so we have positioned ourselves by increasing the risk of adding more bonds into our models.
There is also an expectation of a global economic slowdown and we have repositioned by preferring active managers invested in companies capable of protecting their margins in such a slowdown. From a UK perspective, because of the highly cyclical nature of the FTSE, we have increased our allocation to active fund managers to avoid this cyclicality and have also retained some value exposure (domestic UK companies) because UK inflation is slightly higher than the rest of the world.
When there are signs of a slowdown in US economic activity, equity markets sell off and bond markets rally and like we established before a reduction in interest rates at some point from now till early next year is on the cards. However, any signs of a strong labour markets data gives room for equities to rally with the bond market suggesting the Fed needs to do more to bring inflation down.
Currently, we are evenly split between those two scenarios, but it means it is the right moment to increase the risk of adding more bonds into our models and reduce our overweight position in equity. Diversification appears to be on the cards again, which is what we want, and that will undoubtedly help the performance of the 60/40 investment strategy in our models.
From a fire and ice perspective, if we consider the chart above, the fire scenario doesn’t tend to happen frequently but disinflation accounts for a huge proportion, which means this is expected to occur more. Our view is that the market cycle is currently in the disinflation quadrant and that gives room for the 60/40 strategy to outperform and an opportunity for us to get more returns going forward.
Conclusion
We believe the focus of markets has shifted from inflation being a major concern to the risk of a recession. This is why we have refocused our attention on the 60/40 equity/bond allocation. We expect equity market volatility to increase over the coming months. In the years following the Global Financial Crisis (and during the pandemic), central banks were too eager to cut rates and inject liquidity into the financial system.
We are not sure these actions can be repeated going forward as inflation is likely to be with us for a while. And while this may be the case, we are aiming to protect to the downside by controlling equity risk. Fixed income provides further diversification, and our models are repositioned at a higher yield in the portfolios than it was three months ago.
This ensures the models are positioned for what lies ahead, that is, high yields which will soon peak and as these yields start to fall, investors benefit from the increase in the value of the bond portfolio. That will offset weak returns from the equity component as economic activity slows down and investors benefit from the negative correlation effect. This will make the 60/40 strategy very attractive to investors from a risk perspective.
By Charles Younes, Head of Manager Selection, FE Investments
