Private assets

3 min read

Markets may be too optimistic about 60/40 prospects

Jake Miller
Jake Miller Co-Founder, Chief Solutions Officer

December 14, 2022

Private assets

3 min read

Contents

Key takeaways

  • The last decade was the best on record for the 60/40 equity/bond portfolio. In contrast, the decade starting in 2022 is one of its worst to date (see chart).
  • Moving forward, markets expect a relatively smooth stabilization in inflation. In our view, what’s priced-in is on the optimistic end of outcomes for a 60/40 portfolio. And that creates meaningful downside risks.
  • History shows it’s possible for the 60/40 to underperform cash instruments for sustained periods. In fact, this has been true about a quarter of the time.
  • Advisors may want to prepare for this potential downside scenario. We recommend exploring alternative sources of return with diversified performance drivers.
60/40 cumulative excess returns, 10-year periods, every 2 years starting 1856
Source: Global Financial Data, as of November 30, 2022

Over the last forty years, the 60/40 equity/bond portfolio’s performance was supported by muted inflationary pressures and declining interest rates. Now, the strongest inflationary pressures since 1980 (see chart) are forcing the Federal Reserve to tighten policy at the expense of growth.

Inflation at 40-year highs is forcing the Fed to tighten policy
Source: Bureau of Labor Statistics, as of October 15, 2022

Monetary policy tightening affects asset prices immediately, but it flows through to economic conditions at a lag. This makes it difficult for the Fed to calibrate tightening and engineer a soft economic landing - but that is what markets are pricing in. Five-year breakeven inflation expectations are back around target (see chart), but certain underlying economic measures such as earnings expectations suggest confidence that this can be achieved without hurting growth much further.

Inflation expectations have fallen back to Fed target
Source: Federal Reserve Economic Data, as of December 6, 2022

In line with a more rapid easing in inflation, markets are pricing in a halt to policy tightening in the next year or so (see chart).

Markets expect policy tightening to end next year
Source: Federal Reserve Economic Data, as of November 30, 2022

This general uncertainty leaves the 60/40 vulnerable to inflation surprising to the upside or growth surprising to the downside from here, and both are possible outcomes. What is clear is that current market valuations skew towards the optimistic end of the spectrum.

For inflation upside protection, advisors may want to seek inflation-protected, or “real”, return streams, like inflation-linked bonds, private credit, and real assets (if they are capturing the right type of inflation). For growth downside protection, it might be wise to seek out alpha-generating alternatives to public equity allocations.

To explore how Opto can partner with you to help you and your clients achieve your goals, please get in touch with us at advisory-services@optoinvest.com.

 

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