As markets grapple with the effects of inflation and rate hikes, the 60/40 portfolio could experience a revival. However, this possibility relies heavily on what central banks do next.
The 60/40 investment portfolio, which allocates 60% to equities and the remaining 40% to fixed income, has fallen out of fashion during a time when equities and bonds have moved in lockstep with one other.
For equity markets, which enjoyed almost uninterrupted growth for much of the decade leading up to the pandemic, the year so far has been less kind. Inflationary pressures have dampened prospects and rotated the investment cycle away from growth stocks, while the subsequent rise in real interest rates have translated into negative returns for many stock markets, particularly in the US.
Bonds are historically seen as offering a layer of defence in times of market stress. In the current environment, however, bond markets have also been following a downward trend, on the back of the interest rate hiking cycle instigated by central banks. In fact, as of early May, bond markets had had the worst start to a year since 1842.
Given how both equities and bonds have performed over the past year, there have been few places for investors to hide.
However, while the relationship between equities and bonds in portfolio construction has clearly broken down this year, we expect it to recover for the next cycle. Any such recovery will rest upon repricing and valuations.
Are central banks pushing too hard, too quickly?
Central banks are currently lashing at inflation with as many rate hikes as each can muster. In response, the market has tried to pre-empt how far the central banks will go, pricing in another ten rate rises in the US and a further six to eight in Europe.
Whether the central banks can truly deliver on these projections is the question hanging over investors at present, with many analysts fearing that the US Federal Reserve (Fed) and others may have pushed too hard, too quickly, and risk triggering a recession.
Any such event in 2023 or 2024 would likely see interest rates moving back down and policy rates being cut, meaning that this hiking cycle had been designed to be short and sharp.
Speed is of the essence, which would explain the Fed having bumped their rate rises from increments of 25bps to 50bps. It’s a race against the clock for rates to go higher and inflationary forces to ease, as there will soon come a point where the conversation tilts towards rates peaking, recession and, ultimately, rate cuts. We believe that, at this stage, the 60/40 strategy will come back into play.
The outlook for recession and stagflation
This is very much the scenario ‘as things stand’ but market events are always subject to change. The key risks from here lie in a continued rise in interest rates, beyond that of analyst expectations. This would be triggered by a persistent buoyancy in inflation, and the underlying factors that are provoking it, nullifying central bank intervention, and forcing policymakers to go further.
Such factors have been well documented and include a continued disruption of global supply chains, rising energy and oil prices (reinforced by the ongoing conflict in Ukraine) and wage growth, which the US has been experiencing.
Should these elements remain in play for longer than expected, interest rates could well be forced higher. However, it is important to remember that peak hawkishness will eventually arrive, and at this point, fixed income will likely return to its status as a safe haven for capital, as recession creeps into the global economy.
We are of course mindful of the prospect of stagflation, an environment of low growth and high inflation, which could correctly be summarised as the worst-case scenario for all risk assets, including bonds.
This eventuality remains in play, as signs of the global reopening trade appear to be waning and consumers are now more directly impacted by the rise in prices. The central banks do have the tools necessary to avoid such a scenario however – namely, a cut in interest rates.
With this in mind, adopters of the 60/40 strategy should keep a keen eye on the horizon, as these allocations will look more favourable once fears of recession have been fully reflected in valuations. As ever with markets, timing will be the challenge for investors, but we do believe this is a case of ‘when’ rather than ‘if’.
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The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
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Expiry date 30/06/23