The traditional 60/40 portfolio, a staple of financial planning for decades, with a 60 per centallocation to equities and 40 per centto bonds, has been a simple and reliable strategy for investors seeking a balance between risk and return.
However, with the current economic landscape marked by higher inflation and interest rates, is it time to question the viability of this classic allocation model?
The changing financial landscape
The 60/40 model, a goodbut simple rule of thumb, has worked well in the past, primarily because of the nearlyfour-decade long bond bull marketafter the high interest rates of the 1980s decreased (until the past year turned the tide) and because of the negative correlation between stocks and bonds.
When stocks underperformed, bonds tended to perform betterand vice versa, providing a cushion for the portfolio.
However, in this world that is different to the past 25 years, investors may need to reassess their beliefs.
For example, as inflation risescentral banks typically respond by raising interest rates to curb inflationary pressures. This action directly impacts bonds, as their prices fall when interest rates rise.
A lower bond price occurs when interest rates rise because investors with spare cash can now earn more on newer higher yielding bonds, so the price of the existing lower yielding bond would need to fall to give investors a reason to want to buy it.
Consequently, the traditional role of bonds as a hedge against equity market volatility might be compromised in a higher inflation and interest rate environment.
Looking at nearly 100 years of data brings this to light.
The 2000 to 2021 period is the standout and makes us question whether we are simply reverting to what should be a more normal relationship between the two asset classes.
Assuming the outlook is for higher inflation and interest rates, what should you do for your clients in this world?
A shift in the portfolio allocation paradigm?
Some investors are considering reversing the traditional 60/40 allocation, that is, allocating 60 per centto bonds and 40 per centto equities.
This approach might appear attractive on face value, especially if one anticipates a period of stock market volatility or a stock market price downturn.
However, it is crucial to keep in mind that bonds would also face headwinds from rising inflation rates, and this means that bonds will more volatile than they have been in the past 25 years.
So, while higher interest rates are more attractive, investors need to balance a higher bond return against inflation and against achieving portfolio returns in the long run.
A directly linked topic is real returns. Directly explained, while bond returns are higher, this is because inflation has increased, so you may not always benefit as much as you think by allocating to bonds in this world.
In a higher inflation and interest rate environment, bonds should indeed be viewed differently, but not for the reason you may think.
The important aspect is about how much bonds provide after inflation is subtracted, as earning returns above inflation is what matters for wealth creation. Again, looking to the past nearly 100 years of data provides insights.
Bonds, while returning 2 per centper yearabove inflation, have not kept pace with stocks over the long run, which have returned nearly triple the real return of bonds over this period.
The impact on your wealth with such a divergence in real returns could be the difference between being able to retire comfortably or not.
So, with this evidence to hand, the question is whether bonds should be viewed differently now.
Historical returns in excess of inflation since 1926 to 2022
Viewing bonds in a new light
In a higher inflation and interest rate environment, bonds should indeed be viewed differently, but not for the reason you may think.
Firstly, bonds do now offer an absolute return, a very different starting point from a few years ago where they offered you close to nothing.
Focusing on this aspect alone makes bonds more attractive.
This, however, does not make them attractive enough for me to start reducing stock allocations to fund fixed income to the degree that the traditional 60/40 portfolio allocation is reversed.
Secondly, while inflation and interest rates are higher, this typically means that bond returns can also be expected to be more volatile than we have been used to over the past 25 years.
When looking at it from a portfolio optimisation perspective, it means bonds are less attractive in an overall portfolio when we consider risk-adjusted returns. It would be wise to assume bonds will have a higher expected correlation to equities in this environment.
We also need to assess what risk matters to investors: short-term volatility reduction or the ability to achieve longer-term wealth goals by growing their assets in real terms.
However, all is not lost for bonds. In a world with inflation surprises, inflation-linked bonds –especially those that can bought directly – could potentially provide a hedge against inflationary pressures as they pay you more if inflation rises.
As investment managers, we need to remain adaptable.
So, in this sense, an unique asset class has the opportunity to come to the fore and complement traditional non inflation-linked nominal bonds.
While the classic 60/40 portfolio may need to be reassessed considering the current economic environment, a simple reversal to a 40/60 allocation may not be the optimal solution, especially when considering long-term wealth creation outcomes.
A more nuanced approach might be required, considering factors such as investment horizon, stock-bond correlation, and the volatility of the bonds themselves.
As investment managers, we need to remain adaptable, reassessing our strategies in response to changing market conditions.
The current economic climate offers an opportunity to reassess the role of bonds in our portfolios and to explore other asset classes – such as alternatives earning more than cash –that can provide diversification and return potential, particularly if the diversifying role thatbonds have played in the past 20 years reverts to what long-term data suggests.
Rob Starkey is a multi-asset portfolio manager at Schroders
