For two decades, traditional balanced portfolios investing 60% in global equities and 40% in global bonds performed well to defy regular forecasts of their imminent demise.
These bellwether strategies beat moderate allocation funds(1) with an equity weighting of 40-65% net of fees in 18 out of 21 years up to 2022.(2)
Only in 2005, 2009 and 2022 did the moderate allocation sector trump 60:40 funds, which equates to outperforming just 14% of the time. In contrast, for the 10 years up until 2002, the moderate allocation sector outperformed 60:40 funds 70% of the time (see table).
|Probability of outperformance
Source: abrdn, Morningstar 2023
What characterised the period from 2002 to 2022 was negative correlation between equities and bonds. That meant that even in periods of extreme equity market stress, bonds helped to offset losses for 60:40 portfolios.
However, recent high inflation – something not seen for most of the past 20 years – has resulted in a sharp change in correlations between equities and bonds, which reduced the diversification benefits in 2022.
Now it is for investors to determine whether last year was an aberration or if the increased correlation between equities and bonds is likely to continue.
Although 60:40 portfolios could perform better over the longer term, we see three reasons to believe this trend reversal will persist in the short term and why 60:40 portfolios could continue to underperform genuinely diversified strategies with flexible asset allocation:
The macro-economic environment is changing.
- Equity and bond indices are increasingly concentrated.
- A change in policy regime could mean the correlation between equities and bonds becomes less predictable from now on.
Our economists believe the global economy is transitioning from overheating to contraction. Growth is resilient but starting to plateau, while inflation is high but starting to fall. Central banks in many developed markets remain hawkish but may pivot to a more neutral stance over the medium term.
However, the transition is taking longer than expected and asset classes are out of step with one another – bond yields and interest rates remain high to combat inflation, while equities are already pricing in a benign growth outlook.
Difficulty in identifying the timing of this transition and how asset classes will react makes this a challenging time for investors.
The US Federal Reserve (Fed) has raised rates 500 basis points since the start of 2022, making this the strongest tightening cycle in 30 years, and our economists anticipate one or two more rises.
But it takes time for policy tightening to work through the system and slow the economy. We believe the transition from overheating to contraction will be delayed, but not avoided.
At some point in the first half of next year we expect the US and global economy to show definitive signs of recession as the impact of high rates takes its toll on growth and earnings.
While 60:40 funds might be able deliver reasonable returns over the long term, their returns over the short term are highly dependent on how quickly inflation falls and the impact this has on growth. In a recession scenario, we estimate that a hedged 60:40 portfolio would return -9.68% over 12 months (see table).
With an improvement in US productivity and a better-functioning jobs market, it’s possible the Fed could slow growth and tame inflation without causing a recession. In this ‘Goldilocks’ scenario, which would be good for equities and bonds, we estimate a hedged 60:40 portfolio would return 6.6% over a 12-month period.
But in a scenario where high inflation remains sticky in the coming months, the Fed would likely be compelled to tighten policy more strongly than forecast. In this case we estimate a hedged 60:40 portfolio would return -13.9% over the same time period.
|Performance of 60/40 portfolio
Source: abrdn 31 May 2023. Portfolio is 60% MSCI World and 40% Global Aggregate, both hedged to USD.
Whichever scenario plays out, the narrowness of the path ahead for a 60:40 strategy over the next 12 months – or indeed any balanced funds that are not genuinely diversified and flexible – will likely be a cause for concern for investors.
Increasingly, the S&P500 Index is being driven by the returns of mega-cap technology stocks, highlighting how the performance of equity markets particularly in the US has become more concentrated and less diversified.
Over the decade to 2022, some 245 stocks outperformed the mean on the S&P500 Index. But this year to end-May, only 118 stocks outperformed the index and the top 10 contributors provided 108% of overall performance (see chart). It means a very small number of stocks have become responsible for driving performance.
Source: abrdn, Factset, 31 May 2023
While index performance could broaden out, it’s also quite possible that it remains highly concentrated, making it especially hard for equity investors to diversify their equity risk.
We’ve seen a major increase in correlation between bonds and equities in the US over the past few years (see chart). This has implications for a 60:40 portfolio, which traditionally relied on negative correlation for diversification and returns in a deflationary world.
Source: abrdn, Refinitiv, May 2023
Under today’s economic environment, neither the growth of equities nor the historically defensive role of bonds are as assured as they were, in our view.
Global markets are only just emerging from a policy regime that began under former Fed chairman Paul Volker and ex-US President Ronald Reagan – characterised by inflation-fighting conservatism amid a backdrop of rising globalisation and deregulation. This led to deflation, low interest rates and booming markets.
But the inflation crisis of the past two years caught most central bankers by surprise. Primarily it was caused by prolonged stimuli to counteract the Covid19 pandemic, supply-chain disruption and the rebound in demand for goods and services. It was exacerbated by Russia’s invasion of Ukraine that sent energy prices rocketing.
While we expect inflation to ease and interest rates to decline eventually, it’s not necessarily the case that the era of ultra-low inflation and low interest rates will return anytime soon. The globalisation that propelled the global economy for two decades once China joined the World Trade Organisation in 2001 has been replaced by greater domestic market protectionism.
Offshoring has become onshoring, the geopolitical sands are shifting and the world is facing new supply shocks such as the war in Ukraine and increased US-China tensions against the backdrop of the green energy transition. We have likely entered a period where elevated inflation will remain more persistent and more volatile than in the recent past.
This being the case, we believe investors will need to increase exposure to real returns via allocation to assets that can benefit from (or at least keep pace with) inflation, such as infrastructure, commodities, floating-rate bonds and real estate.
Looking ahead, we continue to see risks to the base-case for 60:40 portfolios and anticipate that demand will remain strong for non-traditional assets able to offer attractive returns and diversification benefits. Within fixed income, this might include emerging market debt and asset-backed securities, both of which offer differentiated risk-adjusted return potential over time.
We also see an increased role in portfolios for alternatives such as infrastructure, specialist property (such as student accommodation or health care), private equity and special opportunities (such as secured lending to life sciences companies, litigation finance and precious metals royalties).
In many cases, these assets have low sensitivity to economic cycles and inflation and can generate differentiated revenue streams that aren’t tied to rises and falls in the market.
While these asset classes were traditionally only available to institutions and wealthy investors, now they’re accessible to individuals via closed-end funds listed on exchange. History indicates listed alternatives outperform global equities in times of recession. The chart below shows generally higher 5-year return expectations for alternative versus traditional assets.(3)
Finding a balance
Investors face a challenging environment in which high and potentially volatile inflation threaten to undermine the diversification benefits of a traditional balanced approach.
As we look ahead, we believe investors will be searching for three things above all: stable income; attractive long-term returns; and the ability to diversify to mitigate risk and volatility.
As such, we think they will benefit from accessing a much broader range of asset classes, including alternative assets with low sensitivity to the economic cycle and to traditional markets.
In addition, we believe that generating returns in this environment will require a more flexible approach to asset allocation.
- We use USD Moderate Allocation Morningstar Sector return, which is the equal-weighted return of funds in the sector, to show the return of funds vs 60:40.
- Analysis by abrdn, Morningstar of 1992-2002 and 2002-2022.
- Source: abrdn, DA Return Assumption as at 1 January 2022 over 5 years p.a. in EUR and includes allowance for outperformance within some asset classes and from tactical asset allocation. Forecasts are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially. For illustrative purposes only. Figures may not add up due to rounding. Expected return is not an indication of future results.