Rising stagflation risks in the US and Europe raise the possibility of a “lost decade” for the 60/40 stock/bond portfolio mix, which has historically been seen as a solid choice for investors with moderate risk appetite.
This “lost decade” is defined as an extended period of low real returns, says Goldman Sachs Group Inc., portfolio strategist at Goldman Sachs Group Inc. GS, +0.66% Christian Müller-Glissmann and his colleagues Cecilia Mariotti and Andrea Ferrario. Since the beginning of 2022, 60/40 portfolios in the US and Europe have fallen more than 10% in real terms, according to a note published on Friday.
Downside risks plus inflation are heightened by the Russian invasion of Ukraine and are already affecting many investors. The three major US stock indexes have fallen 5-12% this year, with the high-tech Nasdaq Composite COMP falling the most. Meanwhile, bonds are also having a tough time, with the 10-year TMUBMUSD10Y treasury bond yielding 2.144% posting its worst year-over-year performance since 2013 as of Thursday, pushing its yield above 2.1%. This reduced the effectiveness of the 60 percent allocation to equities and the 40 percent allocation to bonds.
Signs of stagflation fears are evident in the betting markets. The break-even 10-year U.S. inflation rate, a measure of inflation expectations, has reached its highest level since the 1990s, according to Goldman Sachs. Meanwhile, inflation-adjusted real yields remain near the lowest levels in decades, reflecting pessimism about economic growth in the coming years. And the well-known spread between 2-TMUBMUSD02Y, 1.961%, and the 10-year Treasury yield is gradually approaching the inversion that is usually a precursor to a recession.
Datastream, Haver Analytics, Goldman Sachs Global Investment Research
“The number one problem with a 60/40 portfolio is that the rate of inflation means real bond yields will be negative,” said John Sylvia, founder and CEO of Dynamic Economic Strategy in Captiva Island, Florida. “And slower economic growth means slower earnings growth, which means the stock portfolio is also suffering.”
“Therefore, the portfolio’s overall performance is likely to be disappointing compared to past years, and it could fully hold out for a full decade,” Sylvia said by phone. “The reason is that you had arbitrarily low interest rates for four to five years and a lot of speculation in the market with people chasing yields. The demise of the 60/40 portfolio has been waiting for a long time, and now it has finally come.”
The lost decade that Goldman Sachs envisions marks a reversal from a previous cycle that has benefited from what Muller-Glissmann and colleagues call “Goldilocks’ structural regime.” It was then that low inflation and real rates pushed up values and profits despite relatively weak economic growth. Stocks and bonds performed well side-by-side, they say, with the 60/40 combination performing in real terms about 7% to 8% each year during the most recent cycle, compared to a 5% average over the long run.
The idea behind the 60/40 combination was primarily that bonds could act as a ballast for the inherent riskiness of equities. Private pension plans are one group of investors who continue to cling to the mix and “rarely deviate from it,” according to Deutsche Bank researchers.
But lost decades happen more often than many think, according to Müller-Glissmann, Mariotti and Ferrario. They happened during World War I, World War II, and the 1970s after strong bull markets marked by higher valuations. In the face of stagflation, the chances of a lost decade rise, they say.
The following chart shows the 1-year and 10-year drawdown in a 60/40 portfolio over decades.
Datastream, Haver Analytics, Goldman Sachs Global Investment Research
A combination of other investments could help mitigate the risk of another lost 60/40 decade for investors, according to the Goldman team. These include contributions to “real assets” such as commodities, real estate and infrastructure, as well as greater diversification in overseas markets. Investors should also look at high-yield and high-yield stocks, as well as convertible bonds, Goldman said.
Of course, not everyone agrees with the idea of a long period of low 60/40 returns. Thomas Salopek, strategist at JPMorgan Chase & Co. JPM, which warned in January that the 60/40 combination was “at risk,” says it believes the US will avoid de facto stagflation and “we believe there will be no lost decade for the 60-year period.” /40″.
“At this point, the environment continues to be characterized by high growth and high inflation,” he wrote in an email to MarketWatch on Friday. As yields have historically risen during the Fed’s rate hike cycle, “there is a healthy risk premium on stocks and bonds that can finally be realized as risk aversion declines. Thus, the superiority of equities should more than offset the weakness of bonds once risk appetite recovers.”
Treasury yields were mixed on Friday as investors weighed in on the prospect of slower growth.