An investing strategy designed to hedge against market declines is rebounding after a rough year, but its success may hinge on whether inflation continues to ebb in coming months.
So-called 60/40 portfolios typically allocate 60 per cent of their assets to stocks and the rest to bonds, though proportions tend to vary. The strategy counts on the two assets balancing each other out, with stocks strengthening in an upbeat economic environment and bonds gaining during uncertain times.
Such diversification failed to benefit investors last year, when stocks and bonds both tumbled as the Federal Reserve raised rates to fight surging inflation. A typical 60/40 portfolio tracked by Vanguard last year suffered its worst annual decline since 2008.
So far, things are looking more hopeful in 2023, with the 60/40 portfolio up about 5.5 per cent in the first quarter, following last year’s 16-per-cent drop, Vanguard’s data showed.
The strategy’s future performance could hinge on how effective the Fed is in bringing down inflation. Signs that consumer prices are staying persistently high could fuel bets on the central bank keeping rates higher for longer, with tighter credit conditions weighing on valuations for equities and lifting bond yields, which move inversely to prices.
Investors are hoping Friday’s monthly jobs report and next Wednesday’s consumer price index will offer more insight on whether the economy is cooling.
Some investors are bracing for more turbulence in both asset classes, fearing that the Fed’s fight against inflation isn’t done. Jack Ablin, chief investment officer at Cresset Capital, has trimmed his bond holdings and increased his allocation to gold, a popular inflation hedge.
“Inflation, and the perception of tighter credit as a result of inflation, is going to hurt both bonds and stocks,” he said. “Once we can get back to that stable state again, past this inflationary period, then I think 60/40 will work again.”
BRACING FOR A DOWNTURN
Nevertheless, the case for diversification has been on display this week. Stocks fell after Tuesday’s labor market and manufacturing data raised concerns that the economy may be weakening. But benchmark Treasury yields drifted lower, at least partially offsetting those declines.
Proponents of the strategy believe its bond component can help blunt the impact of a recession on investor portfolios.
Indeed, benchmark 10-year Treasury yields have declined by about 70 basis points since the start of March, as investors bet that tumult in the banking sector will lead to tighter lending conditions and bring a downturn closer.
Even if inflationary concerns pressure bonds again this year, some investors believe the damage might be softened because rates are already at much higher levels after jumping from near zero last year. After starting 2022 at around 1.5 per cent, the yield on the benchmark 10-year Treasury note last stood around 3.3 per cent.
“We now have yield in the bond market, which we haven’t had for 10 years,” said Paul Nolte, market strategist at Murphy & Sylvest Wealth Management. “The higher yields help mitigate a slow increase in interest rates.”
Mr. Nolte’s portfolios are roughly 50 per cent in both stocks and bonds, as he is bracing for an economic downturn.
“What we are expecting is that if equities do fall apart, it’s going to be because we are going into a recession and we would see interest rates come down,” he said.
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