60-40 equity-bond investment strategy takes a hit

A trader works inside a booth on the floor of the New York Stock Exchange, on Jan 18, 2022. PHOTO: REUTERS

(BLOOMBERG) - A bedrock of long-term investing, a portfolio split 60-40 between equities and high-quality bonds, posted its worst monthly slide since the market meltdown in the early days of the pandemic.

Both equities and bond prices dropped sharply in January as markets priced in a faster pace of interest-rate tightening this year from the Federal Reserve. The United States central bank's hawkish pivot from mid-December last year intensified after last week's policy meeting, with leading Wall Street economists calling for at least five and possibly as many as seven quarter-point rate hikes this year.

The Bloomberg 60-40 index lost 4.2 per cent in January, reflecting a decline of 5.6 per cent for large cap equities and a loss of 2.2 per cent for the Bloomberg US Aggregate bond index. That is the worst showing since a slump of 7.7 per cent in March 2020, when coronavirus lockdowns plunged the economy into recession.

Investors believe much rests on how far the Fed tightens policy and to what degree the pace of inflation, economic growth and corporate earnings slows during the coming rate-hike cycle. Elevated inflation may force the Fed to become more aggressive and spur higher market volatility, eroding the performance of diversified portfolios for an extended period.

"We could be looking at a stagflationary environment where both equities and bonds fall as a result of persistent inflation and low growth," said Ms Nancy Davis, chief investment officer at Quadratic Capital Management.

Benchmark Treasury yields pulled back two basis points to 1.75 per cent recently, coming off the back of a 27-basis-point surge in January, the most in 10 months.

S&P 500 futures fell 0.2 per cent a day after the cash index delivered its worst monthly loss since the beginning of the pandemic. Investors owning a long-term mix of equities and bonds need to look back only to 2018 for how Fed tightening can spark negative returns.

The 60-40 strategy suffered a decline of 2.3 per cent in 2018, only its second annual loss since the Bloomberg index was established in 2007. The other was during the credit market crisis of 2008.

Longer term, the strategy has generated an annualised return of 10 per cent since the early 1980s and is a popular model for retirement plans offered by asset managers to US workers with retirement fund plans.

The attraction of a diversified investment approach is that negative swings for both equities and bonds have typically been brief.

High-quality bonds such as Treasuries have less volatility than equities and usually appreciate in value when risk assets are falling sharply. In turn, equities generate the bulk of returns over time as companies have consistently grown their earnings outside of recessions.

For much of the past decade, a robust performance from owning a 60-40 portfolio has reflected a climate of very low inflation, limited rises in bond yields, and an advancing stock market. That has resulted in a tough environment for generating future returns as both equity and bond valuations ended 2021 at lofty levels.

Before this month's appreciable decline in 60-40 performance, investors had been exploring ways to shift away from that approach. Some have advocated downgrading the bond component as high-quality fixed-rate yields are less than the current inflation rate, eroding the purchasing power of the returns.

A shift away from expensive US large-cap shares towards those of smaller and lower-valued companies in global markets - such as Britain, Europe and the developing world - has also been recommended. Another approach has been tying up money for extended periods in the booming private debt markets, in an effort to find assets that are less correlated with those of publicly traded shares and bonds.

"Our approach to 60-40 strategies is looking more at owning dividend-paying stocks and also allocating more to alternatives, while underweighting bonds," said Mr Anthony Saglimbene, global market strategist at Ameriprise Financial.

Citigroup strategist Alex Saunders wrote in a note last week that adjusting portfolios when growth slows and inflation stays high by "reallocating a 60-40 portfolio to real estate, CTA, quality equity and carry strategies we find delivers similar returns with less volatility and a more robust performance across regimes".

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