William John Market Report 03-06-21
William John Market Report 03-06-21Category: Reports
Is the time of the “60/40” portfolio over? The traditional portfolio, comprised of 60% equities and 40% bonds, has come under major scrutiny in a “twin-bull” market whereby both asset classes have seen historically impressive gains on major indices and depressed yields.
Since circa 2000, U.S. equities and U.S. treasuries have been negatively correlated:
Comparing the risk-free rate of 3-month U.S. Treasury Bills vs. returns on the S&P 500 from 2000 to 2020, they yielded a negative correlation of -0.2142643. As the returns of one asset rises, the returns of the other decreases.
This has been the hallmark of asset management over recent times: “invest 60% of your savings in an S&P 500 index and 40% in risk free treasuries”. The reasoning being that because the two are inversely related, they tend to offset each other’s losses, whilst both earning positive returns; by studying the graph you can see that aside from major recessions and a dip in 2018, both asset classes have produced positive annualised returns.
In financial fields, the 60/40 portfolio with U.S. treasuries has been described by theorists as “free lunch” based on the fact U.S. Treasuries are so credit worthy they are almost riskless yet diversify portfolio risk away from the highly volatile equity.
Studying this portfolio in more depth, research suggests that equities and bonds (high grade corporate and government) tend to move in opposite directions in the case of growth surprises. For example, in bullish markets, investors are likely to purchase stocks on the back of an economic boom and sell government bonds in strong economic conditions whereas in recessionary cycles, investors tend to sell stocks and buy government bonds in weaker economic conditions.
On the contrary, inflation surprises seem to provoke the two asset classes to move in the same direction. Specifically, heightened inflation uncertainty and rising inflation levels causes positive correlation between the two asset classes. The key causal link is heightened inflation uncertainty (driving bullish treasury markets and depressing yields) and monetary policy credibility (driving bullish equity markets whose constituents have relied on solid quantitative easing programmes).
Inflation surprises during the pandemic era is manifesting positively correlated markets which nullifies the “free lunch” diversification effect of the 60/40 portfolio; returns that move in the same direction compounds risk rather than reduce it.
Furthermore, a report released by the portfolio solutions group of AQR has estimated poor returns in these asset classes for the medium term (5-10 years) with expected real returns of Treasuries and U.S. Equity equalling -0.05% and 3.8% respectively. Their estimates for a “Global 60/40” portfolio came in at 2.1% over the same period. They stated in their report “the case for diversifying away from traditional equity and term premia is arguably stronger than ever”.
So, what does this mean for the investor of 2020 to 2030? Safe bonds and index funds that comforted the investor from 2010-2020 may no longer meet investment mandates. Low forecasted returns for each asset class and the positive correlation between the two means that the investor is expecting measly returns for compounded risks. Thus, the investor for the next decade may have to shift away from the 60/40 portfolio and into the realm of Alternative Investments, including investments in but not limited to private equity, real estate, and hedge funds to secure higher returns in an era of “twin-bull” major asset class correlation.
Any opinions expressed in these documents are those of William John and are provided for information only. E&OE.