By Michael Devereux
The idea behind the 60/40 portfolio, which is made up of 60% equities and 40% bonds, relies on the negative correlation between equities and bonds. In others words, if the equity component of the portfolio does poorly, these losses would be offset by gains from the bond component, and vice-versa.
However, the correlation between equities and bonds turned positive in 2022 which meant that the 60/40 didn’t provide the protection it has been known for since the 1990s. Instead, as equities fell over the year, so did bonds. A portfolio made up of 60% US equities and 40% long-term US government bonds, fell 17% last year, underperforming both South African and US inflation by roughly 21.6%.
So is it all over for the 60/40 portfolio? Here’s why we don’t think so.
Firstly, looking back at history, it’s highly unusual to see significant drawdowns in the 60/40 happening in two consecutive years. Indeed, we’re already seeing the 60/40 bounce back after a strongly negative year in 2022.
Secondly, the growth and inflation environment looks relatively favourable. There are signs that global growth is heading for a soft, rather than a hard or ‘no’, landing. A soft landing is characterised by slowing inflation and lower growth that is cushioned by a factor such as excess savings or government support.
Indeed, global growth has been better than expected so far. Growth estimates have been revised higher in many cases around the world.
While inflation estimates appear to have peaked, year-on-year, global inflation has been trending downward and we expect this to continue, especially in the US and Europe, until at least the second half of the year.
All in all, it feels like 2023 should be a more ‘normal’ year in terms of growth and inflation. In this environment, the equity-bond correlation should go back to a negative relationship which means bonds can once again play their diversifying role when combined with equities.
Michael Devereux is a Multi Asset Portfolio Manager at Schroders
** The views expressed do not necessarily reflect the views of Independent Media or IOL.
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