The 60/40 portfolio has for decades provided investors with a relatively safe and straightforward way to diversity their holdings and enjoy healthy returns with low volatility.
That’s until the pandemic severed the link between economic growth and inflation, reducing bonds’ ability to soften losses in stocks and dimming the glow for investors who put 60% of their portfolios into stocks and 40% into fixed-income assets.
Morgan economists predict that growth, inflation and interest rates will start easing this year and next as the global economy finally puts monetary policy driven by COVID and its aftermath in the rearview. That should also help recalibrate the stock-bond correlation and revive the 60/40 portfolio’s appeal, at least in the short term.
But over the long run, the rapid diffusion of generative artificial intelligence, increasing adoption of renewable energy and the increasingly multipolar world are likely to spur investors to fundamentally reconsider how they diversify their holdings. Additionally, increasing global longevity will have reverberations in the bond market over the coming decades, as the world’s growing retirement-age population searches for safeguards against volatility, even it means lower returns.
“Concerns about the widely-used 60/40 strategy aren’t unfounded, but they may be exaggerated,” says Serena Tang, Morgan’s Chief Global Cross-Asset Strategist. “That said, exactly how one thinks about the right mix of equities and bonds to achieve diversification with stability and good returns may need to change.”
Here’s what Tang thinks investors should keep in mind:
What is a 60/40 Portfolio?
The 60/40 strategy evolved out of American economist Harry Markowitz's groundbreaking 1950s work on modern portfolio theory, which holds that investors should diversify their holdings with a mix of high-risk, high-return assets and low-risk, low-return assets based on their individual circumstances.
While a portfolio with a mix of 40% bonds and 60% equities may bring lower returns than all-stock holdings, the diversification generally brings lower variance in the returns—meaning more reliability—as long as there isn’t a strong correlation between stock and bond returns (ideally the correlation is negative, with bond returns rising while stock returns fall).
For 60/40 to work, bonds must be less volatile than stocks and economic growth and inflation have to move up and down in tandem. Typically, the same economic growth that powers rallies in equities also pushes up inflation—and bond returns down. Conversely, in a recession stocks drop and inflation is low, pushing up bond prices.
Is a 60/40 Portfolio Still the Right Approach?
For decades, the patterns fueling the 60/40 strategy held strong, until monetary policy in response to impacts from COVID and its aftermath severed the correlation between growth and inflation.
First, central banks around the world began aggressively cutting rates while governments amped up spending to help support their economies. Two years later, policymakers responded to inflation pressures and began to raise rates while fiscal policy stayed relatively loose. All that led to a spike in bond volatility and dragged bond returns to the lowest levels in decades, reducing the cushion against falling stock prices.
Now with expectations that U.S. interest rates will begin coming down this year, the correlation between growth and inflation should slowly return to normal and bond volatility will likely drop as well.
“In the short term, the traditionally balanced portfolio of equities and bonds may make sense for investors,” says Tang. “As long as bonds are less risky than stocks—and there’s little in the data to suggest they won’t be—bonds should continue to be good diversifiers in a portfolio mixing equities and fixed-income.”
Finding the Right Mix
Over the long term, the 60/40 strategy’s effectiveness will depend on the relationship between economic growth and inflation, which will be greatly impacted by artificial intelligence, renewable energy, the increasingly multipolar world and longevity trends.
Generative AI has been compared to the invention of the Internet or smartphone, and the technology is expected to reshape wide swaths of the labor market, disrupting existing professions and creating new ones while spurring new economic activity.
“Technology diffusion acts like a supply shock, boosting growth and often reducing inflation in the short run,” Tang says. “In other words, the growth-inflation correlation may once again go into negative territory, and the stock-bond returns correlation would once again become positive, although in this case, both equities and bonds could do well.”
Also over the long run, renewable energy may potentially lower energy costs and increase productivity, bringing growth without higher inflation. So as with AI, both equities and bonds would have strong returns. Still other factors, such as government funding of green infrastructure or increased regionalization could alter historic correlations between stocks and bonds.
If it takes longer for volatility in bond markets to ease and for the correlation between stock and bond returns to fall, investors may consider tweaking the formula for stocks-to-bonds in their portfolios as more equity allocation could yield a better risk/reward balance.
“On the whole, given the historic shift in correlations that underpin the tried-and-true 60/40 strategy, we think investors should also consider looking beyond government bonds to other diversifiers to build multi-asset portfolios with flexibility,” says Tang.
For deeper insights and analysis, as your Morgan Representative or Financial Advisor for the full report, “The Future of the 60/40 Portfolio,” (July 11, 2024).
