The 60/40 Portfolio Has Worst Loss Since March 2020 on Fed

(Bloomberg) -- A bedrock of long-term investing, a portfolio split 60/40 between equities and high-quality bonds, posted its worst monthly slide since the market meltdown in the early days of the pandemic.

Both equities and bond prices dropped sharply in January as markets priced in a faster pace of interest-rate tightening during 2022 from the Federal Reserve. The central bank's hawkish pivot from mid-December intensified after last week's policy meeting, with leading Wall Street economists calling for at least five and possibly as many as seven quarter-point rate hikes this year.

The Bloomberg 60/40 index lost 4.2% in January, reflecting a decline of 5.6% for large cap equities and a loss of 2.2% for the Bloomberg U.S. Aggregate bond index. That's the worst showing since a slump of 7.7% in March 2020, when pandemic lockdowns plunged the economy into recession.

Investors believe much rests with how far the Fed tightens policy and to what degree the pace of inflation, economic growth and corporate earnings slow during the coming rate-hike cycle. Elevated inflation may force the Fed to become more aggressive and spur higher market volatility, eroding the performance of diversified portfolios for an extended period.

“We could be looking at a stagflationary 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 pulled back two basis points to 1.75% as of 6:36 a.m. in New York, coming off the back of a 27-basis-point surge in January, the most in 10 months. S&P 500 futures fell 0.2% a day after the cash index delivered its worst monthly loss since the beginning of the pandemic.

Investors owning a long term mix of equities and bonds only need to look back to 2018 for how Fed tightening can spark negative returns. The 60/40 strategy suffered a decline of 2.3% in 2018, only its second annual loss since the Bloomberg index was established in 2007. The other was during the credit-market crisis of 2008.

Popular Model

Longer term, the strategy has generated an annualized return of 10% since the early 1980s and is a popular model for retirement plans offered by asset managers to U.S workers with 401K plans.

The attraction of a diversified investment approach is that that negative swings for both equities and bonds have typically been brief. High-quality bonds such as Treasuries have less volatility than equities and usually appreciate in value when risk assets are falling sharply. In turn, equities generate the bulk of returns over time as companies have consistently grown their earnings outside of recessions.

For much of the past decade, a robust performance from owning a 60/40 portfolio has reflected a climate of very low inflation, limited rises in bond yields, and an advancing stock market. That has resulted in a tough environment for generating future returns as both equity and bond valuations ended 2021 at lofty levels.

Returns Eroded

Before this month's appreciable decline in 60/40 performance, investors had been exploring ways to shift away from that approach. Some have advocated downgrading the bond component as high-quality fixed-rate yields are less than the current inflation rate, eroding the purchasing power of the returns.

A shift away from expensive U.S. large cap shares toward those of smaller and lower-valued companies in global markets -- such as the U.K., Europe and the developing world -- have also been recommended. Another approach has been tying up money for extended periods in the booming private debt markets, in an effort to find assets that are less correlated with those of publicly traded shares and bonds.

“Our approach to 60/40 strategies is looking more at owning dividend-paying stocks and also allocating more to alternatives, while underweighting bonds,” said Anthony Saglimbene, 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 stays high by “reallocating a 60/40 portfolio to real-estate, CTA, quality equity and carry strategies we find delivers similar returns with less volatility and a more robust performance across regimes.”