Investment Insights

Are 60/40 portfolios set for a comeback?

February 2023

FOR PROFESSIONAL / QUALIFIED

INVESTORS ONLY
Marketing communication

Are 60-40 portfolios set for a comeback?

Key takeaways
• 60/40 portfolios have certainly seen better times, having
recorded their worst-performing year since 2008.

Julie Dickson
• A turbulent 2022, however, could be the precursor for a brighter
future especially for investors looking to balance long-term
Investment Director growth of capital, conservation of principal and current income.
• In this whitepaper, we will be highlighting three factors that could
potentially drive a comeback for 60/40 portfolios in 2023 and
beyond.

The classic 60/40 split between equities and fixed income has been a mainstay
of balanced portfolios ever since the concept was invented by economist Harry
Markowitz in 1952. The rationale behind the 60/40 split was simple – to seek to
provide investment returns while assuming a lower level of risk compared to a
pure equity portfolio. In theory, the bond sleeve would offset the volatility of its
equity brethren when equity markets were finding it tough.

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 Yet questions are now being asked of this traditional investment approach
following a dismal 2022. Global equity markets recorded sharp declines over the
past year with the MSCI All Country World Index (net dividends reinvested)
losing 18.4%1. And instead of hedging the fall, fixed income also went
underwater with the Bloomberg Global Aggregate Total Return Index falling
16.2%1.
The acute declines followed a post-GFC (global financial crisis) era of low
inflation, low interest rates and multiple rounds of quantitative easing. 2022 saw
the reversal of these factors. High inflation and higher interest rates took centre
stage instead, triggering fears that the US and Europe could fall into a recession.
A key impact of high inflation is that it tends to coincide with a higher
equities/fixed income correlation. One explanation for this phenomenon is that
when inflation gets higher, so does the uncertainty in inflation expectations.
Riskier inflation expectations would lead to higher bond premiums and therefore
lower bond prices. The combination of high inflation and higher bond yields
would also imply a higher discount factor for equities, triggering lower stock
prices.

Correlation between global equities and global fixed income has increased

1.00
0.80
0.60
0.40
0.20
0.00
-0.20
-0.40
-0.60
-0.80
2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Rolling 52-week correlation Long-term average

Data based on weekly returns in USD from 1 January 2001 to 31 December 2022 for
global equities: MSCI All Country World Index (net dividends reinvested) and global fixed
income: Bloomberg Global Aggregate Total Return Index. Long-term average represents
the average correlation over the entire period.

With the correlation between equities and fixed income jumping to its highest
level in more than 20 years, performances naturally took a hit in 2022, given that
leveraging the diversification benefits between equities and fixed income is a
fundamental aspect of 60/40 portfolios. For example, a hypothetical portfolio
investing in 60% MSCI All Country World Index (net dividends reinvested) and
40% Bloomberg Global Aggregate Total Return Index would have returned
-17.3% in 2022 – its worst yearly return since the end of the GFC in 2008 (see
chart on page 3).

Down but not out

2022 was far from a smooth year for 60/40 portfolios. But uncertainties
surrounding central bank policy responses, the slowing of the global economy,
an ongoing war in Ukraine and the change in market leadership from growth to
value stocks meant there remains a strong need for investors with a more

Data as at 31 December 2022. Returns in USD. Source Datastream

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 conservative risk profile to seek investment solutions that may balance long-term
growth of capital, conservation of principal and current income.
We believe 60/40 portfolios offer that option and investors should not overlook
their long-term credentials because of a single bad year. If we were to look at a
hypothetical 60/40 portfolio over a longer time frame, performances have been
consistently solid, with positive returns in 15 out of the past 20 calendar years.
Most importantly, in the five years where results were in negative territory, only
two (2008 and 2022) were double-digit declines – a testament to the long-term
resilience of 60/40 portfolios.

Weaker years for a 60/40 portfolio are typically followed by stronger years
Historical calendar year results for a hypothetical 60/40 portfolio

Year Return, %

2002 -5.9
2003 25.2
2004 12.9
2005 4.6
2006 15.1
2007 10.9
2008 -25.9
2009 23.3
2010 10.2
2011 -2.1
2012 11.5
2013 12.1
2014 2.8
2015 -2.5
2016 5.7
2017 17.1
2018 -6.0
2019 18.6
2020 14.0
2021 8.8
2022 -17.3

Results in USD terms from 1 January 2002 to 31 December 2022 based on a hypothetical
investment in 60% MSCI All Country World Index (net dividends reinvested), 40%
Bloomberg Global Aggregate Total Return Index rebalanced monthly.

During our analysis of a hypothetical 60/40 portfolio, we also found that calendar
years of negative results are typically followed by calendar years of strong
positive results, reaffirming our belief that investors should consider, rather than
be unduly concerned about 60/40 portfolios. While the investment environment
and external influences driving portfolio results can vary greatly from one year to
another, here are three important factors that could potentially drive 60/40
portfolios to do better in 2023 and beyond.

1. Peaking inflation and normalising correlation

A reduction in inflation from its recent high levels could in turn bring the historic
relationship between global equities and global fixed income to normal levels.
Inflation in the US has already begun to fall from its recent highs, and while the
Federal Funds Rate did increase following the most recent December 2022
Federal Open Market Committee (FOMC) meeting, it was by 50 basis points.
This was lower than the previous four increases of 75 basis points.
If inflation continues to decline the Federal Reserve (Fed) will likely slow its
interest rate-rising policy. In that scenario, high-quality bonds should again offer

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 relative stability and greater income. Lower inflation could also benefit equities
as a lower cost of capital could lead to improvements in profit margins, revenues
and therefore earnings growth, although the actual impact may vary significantly
across different sectors.

Annual Consumer Price Index (%)

12%
United States
United Kingdom
10.1%
10%
9.3%
Euro area
8%
Japan 7.1%
6%

4% 3.7%

2%

0%

-2%
Jan 2020 Jul 2020 Jan 2021 Jul 2021 Jan 2022 Jul 2022

Data as at 30 November 2022 except for Japan, for which data is as at 31 October 2022.
Consumer Price Index (CPI), a commonly used measure of inflation, measures the average
change over time in the prices paid by consumers for a basket of goods and services.

2. Pain from recessions won’t last forever

While higher interest rates are necessary to tame inflation, tighter monetary
policy could also place undue pressure on the underlying economy. The global
economy certainly appears to be under a lot of stress with Europe likely already
in a recession, exacerbated by the war in Ukraine. China’s growth has stalled due
to prolonged COVID-19 lockdowns that the country is only beginning to unravel.
And the US economy, while stronger than most, also appears headed for a
downturn.
Recessions are painful. But they are necessary to clean out the excesses of prior
growth periods, especially the more or less uninterrupted growth investors have
enjoyed over the past decade. Another potential bright spot is that recessions
do not historically last very long. Our analysis of 11 US cycles since 1950 shows
that recessions have ranged from two to 18 months, with the average lasting
about 10 months.
In addition, stock markets usually start to recover before a recession ends. Stocks
have already led the economy on the way down in this cycle, with nearly all major
equity markets entering bear market territory by mid-2022. And if history is a
guide, they could rebound about six months before the economy does.

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 Stocks have typically been a leading indicator of the economy

Past results are not a guarantee of future results.

Data reflects the average of completed cycles in the US from 1950 to 2021, indexed to
100 at each cycle peak. Corporate earnings calculated by Strategas for all completed
cycles from 1/1/1928 to 31/10/2022

3. Income is back
“Investing in fixed income
during a time of high High inflation and hefty rate hikes by the Fed provided a challenging backdrop
inflation and rising rates can for bond markets in 2022. While painful to endure in the moment, these losses
seem worrisome. However, can set the stage for higher income down the road. The yield on 10-year US
today’s starting yields offer Treasury bonds climbed to 4.27% in October 2022, the highest level since June
an attractive entry point for 2008. Yields, which rise when bond prices fall, have soared across sectors. Over
investors” time, income levels should increase since the total return of a bond is made up
of price changes and interest paid — and the interest component is now much
Mike Gitlin higher.
Head of Fixed Income The return of income in fixed income has brought a renewed focus toward the
asset class. At current yields, history would suggest higher total returns over the
next few years. This is indicated in the chart below, which shows average
annualised five-year returns when yields were at similar levels to those available
today.

Investing at current yields has provided attractive returns

Average five-year forward returns for Global Aggregated Bonds from different
starting yields

8.0 Current yield, 3.5%

Average 5 yr Fwd Return,

7.0
6.0
5.0
4.0
%

3.0
2.0
1.0
0.0
0.0 1.0 2.0 3.0 4.0 5.0 6.0
Starting yield, %

Past results are not a guarantee of future results. Forecasts shown for illustrative
purposes only.
Based on yields and average monthly returns in USD for Bloomberg Global Aggregate
Index from January 2003 to December 2022 when in a +/–0.30% range of yield-to-worst
shown

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 Overall higher yields mean that investors have the potential to earn more income
from bonds. This could also provide more of a cushion for total returns, even if
price movements remain volatile. For an active manager, this market presents
compelling opportunities to find value, though selectivity remains a crucial
factor.
Income could also be playing a more prominent role in equities going forward
as the market pivot away from growth stocks over the past year has brought the
dividend component of total stock returns back into focus. While dividends
accounted for just 16% of total return for the S&P 500 Index in the 2010s,
historically they have contributed an average of 38%. The same figure even
climbed to more than 70% during the inflationary 1970s period.
With growth slowing, the cost of capital rising and valuations for less profitable
companies declining, dividends could become a more significant and stable
contributor to total returns in this new market landscape.

Look for dividends to account for a larger portion of total returns

Past results are not a guarantee of future results.

2020s data is from 1 January 1926 to 30 November 2022 in USD terms. Sources: S&P Dow Jones Indices LLC. * Total return for the
S&P 500 Index was negative for the 2000s, so dividend contribution cannot be calculated.

Moreover, the repricing we are seeing in many traditional areas of growth — such
as software, social media, digital payments and semiconductors — could also
create select opportunities for bottom-up investors. The key is uncovering
businesses that are able to successfully adjust to the new reality of higher interest
rates, scarcer availability of capital, readjustment of supply chains and higher
labour costs.

Julie Dickson is an investment director at Capital Group. She has 29

years of investment industry experience and has been with Capital
Group for seven years. Prior to joining Capital, Julie worked as the
head of client portfolio management at Ashmore Group. Before
that, she was the head of client portfolio management at Aviva
Investors. She also held various positions at Axa Rosenberg, Mellon
Global Investments, Barclays Global Investors and Merrill Lynch. She
holds a bachelor’s degree in business management with
concentration in finance from Cornell University. She also holds
both the Investment Management Certificate and the Chartered
Financial Analyst® designation. Julie is based in London.

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