Revisiting the 60/40 portfolio

Bryan Dooley

The traditional 60/40 portfolio, where 60% is invested in stocks and 40% in bonds, is often considered the asset allocation bedrock for investors who can take a bit of volatility but still want to protect principal and grow capital over time. Investment advisors then tend to adjust the mix based on each investor’s risk tolerance, time horizon and market conditions. Backed by strong risk-adjusted returns over time, the 60/40 mix may be considered the gold standard of financial planning.

The risk-reduction feature of this strategy is that historically, when stocks suffer from recession fears, bonds tend to rally because the Federal Reserve and other central banks typically reduce interest rates to backstop the economy. When interest rates fall, bond prices rise, providing a shock absorber for the total portfolio as they help cushion portfolio returns when riskier assets are falling.

While in years past, a diversified portfolio protected investors against sharp downturns, this year has been different. In fact, a US 60/40 portfolio has fallen about 15% so far this year, marking the largest decline since 2008 as stocks and bonds fell together. Because investors are expecting an inflationary recession, or stagflation as it is sometimes called, asset classes of all types have been bid lower this year.

Aggressive central bank policies, soaring inflation and the looming possibility of a global recession have conspired to hurt securities prices across the board. Each tick up in the equity markets seems to be met with equal amounts of selling. Last week, we saw a one-day 1,200-point-plus drop in the Dow Jones Industrial Average and a 5% drop in the NASDAQ, essentially wiping out the prior week’s gains.

Some are referring to a Fed ‘call’ instead of a Fed ‘put’. To explain, in years past the Federal Reserve could be relied upon to support the market during times of economic stress. The dual mandate of the world’s largest central bank has always been to maintain price stability by controlling inflation and to keep the country operating at or near full employment, but in recent years the Fed has also kept an eye on the equity markets.

This is likely because approximately 56% of Americans now own stock. Even though the Fed has no explicit mandate to support the stock market, in this millennium, central bankers have understood the knock-on effect of volatile markets to the broader economy.

However, that narrative changed with Fed Chairman Jerome Powell’s now infamous speech at Jackson Hole this summer where he declared war on inflation. By putting job growth on the back burner and inflation front and centre, Powell and his committee may now see advances in equity prices as an invitation to hike interest rates further, allowing them more scope in the war on inflation. The former protective ‘put’ may now be a restraining ‘call’ option. Some economists believe the Fed would be happy to see as many as 2 million American jobs lost if that helps cool inflation by slowing down wage increases.

Despite the hawkish rhetoric, markets have managed to stage periodic advances. Notwithstanding last week’s sell-off, the 60/40 portfolio is still in positive territory for the current quarter and its long-term track record remains intact. Going back to 1926, a balanced 60/40 portfolio has returned 8.77% annually on average with positive returns in 72 out of 94 years according to a recent Vanguard study.

With so many lengthy articles on inflation hitting the press, it seems as though everyone is now an expert on the topic of the day. While indeed many variables affect the inflation level, the latest blow-up in prices comes down to one overriding factor: the Federal Reserve simply printed too much money during the past few years and now they need to reverse the blunder.

Although labour shortages, supply-chain bottlenecks and the war in Ukraine have contributed to rising consumer prices, history tells us that inflation essentially happens when the money supply grows faster than the economic output under otherwise normal economic circumstances.

In the five years prior to 2020, the beginning of the pandemic, the US money supply had been steadily growing at a rate of about 5.6% annually, using a common measure known as M2. Then, in early 2020 when COVID started, the Fed suddenly turned on the spigot to a degree never seen before. During 2020 and 2021 the Fed increased the money supply at a whopping 25% per year, or over four times the normal amount.

In this period, the Federal Reserve’s balance sheet also more than doubled from about $4.15 trillion to $8.75 trillion at the end of last year. The Fed created money by buying bonds and mortgages for cash and these securities ended up on their balance sheet.

Hawkish Fed speeches, higher interest rates and sticky inflation are all headwinds, but investors should not underestimate the resiliency of the strongest companies. Well-managed corporates which survived the COVID recession and the Great Financial Crisis have learned to adapt to the changing whims and ambitions of elected and unelected politicians.

We recommend maintaining focus on best-of-breed companies while looking for opportunities to own both their debt and equity at attractive levels. Some investors had written off the 40% fixed income position in the traditional 60/40 portfolio, as rising rates hurt the prices of existing bond issues. And yet, bond portfolios are now gradually benefitting from their ability to reinvest maturities and coupons at progressively higher rates of interest. Two-year Treasury notes which paid just 0.22% one year ago now pay almost 4.0%.

Also in the good news category, money supply has not grown since the beginning of the year while the Fed’s balance sheet has actually begun to shrink. This should be constructive for future inflation prints. When the Fed finally does succeed in getting close to its goal of 2% inflation, markets will applaud a moment of success and patient investors will ultimately be rewarded.

Bryan Dooley, CFA, is the chief investment officer at LOM Asset Management Ltd in Bermuda.

Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.