(Bloomberg) — A foundation of long-term investing, a portfolio split 60/40 between equities and high-quality bonds, posted its worst monthly slide since a market downturn in the early days of the pandemic.
The prices of both equities and bonds fell sharply in January as market interest rates rose sharply through 2022 from the Federal Reserve. The central bank’s sharp pivot has intensified since mid-December following last week’s policy meeting, in which leading Wall Street economists called for at least five and possibly seven quarter-point rate hikes this year.
The Bloomberg 60/40 Index dropped 4.2% in January, reflecting a 5.6% drop for large-cap equities and a 2.2% drop for the Bloomberg US Aggregate Bond Index. This is the worst performance since a 7.7% fall in March 2020, when the pandemic lockdown plunged the economy into recession.
Investors are concerned about how far the Fed tightens policy and the extent to which inflation, economic growth and corporate earnings are slowing during the coming rate-hike cycle. Increased inflation could force the Fed to become more aggressive and lead to higher market volatility, destroying the performance of diversified portfolios for an extended period.
“We may be seeing a stagnant environment where both equities and bonds fall as a result of persistent inflation and low growth,” said Nancy Davis, chief investment officer at Quadratic Capital Management.
Benchmark Treasury yields were back two basis points to 1.75% as of 6:36 a.m. in New York, falling behind a 27-basis-point increase in January, the highest in 10 months. S&P 500 futures fell 0.2% a day after the cash index posted its worst monthly loss since the start of the pandemic.
Investors owning a long-term mix of equities and bonds only need to look back in 2018 to see how the Fed tightening could yield negative returns. The 60/40 strategy suffered a 2.3% drop in 2018, only its second annual loss since the Bloomberg index was established in 2007. The second was during the credit-market crisis of 2008.
Over the long term, the strategy has generated annual returns of 10% since the early 1980s and is a popular model for retirement plans offered by asset managers to American workers with 401K plans.
The attraction of a diversified investing approach is that the downside volatility for both equities and bonds is usually brief. High-quality bonds such as treasuries have less volatility than equities and usually appreciate in value when riskier assets are declining rapidly. In turn, equities generate massive returns over time as companies consistently increase their earnings outside of recessions.
Over the past decade, owning a 60/40 portfolio has demonstrated a strong performance reflecting very low inflation, limited growth in bond yields, and a booming stock market environment. This has resulted in a difficult environment to generate returns in the future as equity and bond valuations have ended 2021 at higher levels.
Before the significant drop in this month’s 60/40 performance, investors were looking for ways to move away from that outlook. Some have advocated downgrading the bond component because the yield of a high-quality fixed rate is lower than the current inflation rate, reducing the purchasing power of returns.
A shift from expensive US large-cap stocks to smaller and lower-value companies has also been recommended in global markets such as the UK, Europe and developing countries. In an effort to find less correlated assets with publicly traded stocks and bonds, another approach is tying money up for extended periods of time in booming private debt markets.
“Our approach to 60/40 strategies is focusing more on owning dividend-paying stocks and having a greater allocation for options,” said Anthony Saglimbin, global market strategist at Ameriprise Financial.
Citigroup Inc. strategist Alex Saunders wrote in a note last week that adjusting portfolios when growth slows and inflation remains high should “reinvent 60/40 portfolios for real-estate, CTAs, quality equities and carry strategies.” : By allocating we provide equal returns with less volatility. And more robust performance across all systems.”
—With assistance from Liz Capo McCormick.