Is it time for the 60-40 portfolio to grow up?

Amid Federal Reserve tightening, investors should look for 'escape routes' in fixed income, says asset allocation strategist

Is it time for the 60-40 portfolio to grow up?

With the seemingly tandemed drop in both stocks and bonds over recent periods, investors and advisors might be rightfully concerned that the traditional 60-40 balanced portfolio of stocks and bonds might not be able to live up to its original promise of diversification and performance. But according to Dec Mullarkey, Managing Director, Investment Strategy and Asset Allocation at SLC Management, it’s likely too early to throw in the towel.

“If you look back over the past 15 to 20 years, you’ll see that the 60-40 portfolio does pretty well when the Fed is loosening,” Mullarkey said in a recent interview with Wealth Professional. “And in fact, over that period, a lot of that was actually happening in all of those years.”

He said bonds have generally performed well since the turn of the millennium, except in 2013, when they were slightly negative but were offset by an 30% advance in the stock market. But this year through the end of April, U.S. stocks were down by about 14%, while bonds declined by 10%, putting the balanced portfolio on track for its worst year of performance in recent memory.

“In 2008, the 60-40 portfolio ended up being down 20% for the whole year. The stock market was down 36%, but bonds were up 5%, which helped a little,” Mullarkey said. “The fact that both stocks and bonds have been down this year has been kind of a shocker to investors.”

It certainly is a tough time for the fixed income space. As of the end of April, the 10-year Treasury had gone down for the year by 10%. The Federal Reserve is also tightening the screws on interest rates – it followed the Bank of Canada’s lead with a 50-basis point hike in its most recent policy decision – which foreshadows more stress for the 60-40 portfolio, at least for the near term.

“When you look at the relevance of the 60-40 portfolio going forward, it will be a tough year again in a tightening cycle,” Mullarkey said. “It's hard to find other escape routes, and I think the 60-40 may have to grow up as we go forward.”

Investment-grade bonds could be a potential pivot point. While it hasn’t happened yet this year, Mullarkey says there’s room for spreads between equities and IG bonds to compress. In fact, spreads widened in both the U.S. and Canada following Russia’s invasion of the Ukraine, and have only recently started to come back in.

“Lael Brainard, one of the most dovish members of the Fed, more recently said that it should be accelerating the reduction in its balance sheets,” Mullarkey said. “She’s been one of the longest-tenured holdouts against tightening rate policy, so the market took that as a very strong signal that the Fed is going to move.”

There are glimmers of hope for the 60-40 portfolio. Because corporate balance sheets have cleaned up over the past few years, expectations for corporate defaults in the next year or two have declined, creating a potential benefit for investors that move more of their fixed-income allocations into U.S. corporates.

“A lot of target-dated funds are managed based on a 60-40 allocation, and they’re rebalanced based on maturity. So some of those will certainly come under pressure,” Mullarkey said. “And I think investors will start to see that showing up in their portfolio performance.”