Saying this year has been tough for investors is an understatement. Equities and bonds, traditionally seen as counterweights to one another, have fallen in tandem. Investors are now questioning whether the traditional defensive assets seen as the core diversifier for any investment portfolio offer the security they once did, and if the 60/40 portfolio is still relevant or consigned to history.
Bond markets have experienced heavy falls this year, particularly UK gilts and Index-linked gilts. These can be attributed to the large shift upwards in inflation expectations, exacerbations caused by fiscal policy and a failure to match the Fed in its hiking program. In addition, UK Gilts tend to be of longer maturity than, say, US Treasuries and Bunds, and this profile increases the sensitivity of gilts to interest rates movements. So outsized falls have been experienced in comparison.
UK 10-year Gilt Yield. Source: Financial Times
The chart above shows the huge shift in UK gilt yields, with the 10-year UK Gilt yield rising 282% in 1 year. The Sterling credit market had an equally tough if not slightly worse year with the ICE Bofa Sterling Corporate index down 25.07%. Traditionally defensive assets haven’t offset the equity declines seen this year.
Is the 60/40 portfolio broken?
Some investors believed the 60/40 approach was broken, but advocates have been proven correct over the longer term. Fundamentals in fixed interest have changed dramatically and 60/40 has returned to favour, signalling the benefits of a long-term mindset and outlook.
The long bull market seen in bonds is attributable to a drawn-out period of falling interest rates. When yields fall, bond prices rise. During Covid the Bank of England base rate went to 0.1% in a bid to reduce economic damage. From this level, bond prices theoretically didn’t have much further to appreciate unless the next move was 0% or negative. Therefore, the probability of further capital gains essentially evaporated.
Given the falls in fixed interest markets seen over the last year, the prospect for material capital gains in bonds is once again a reality, along with the probability of the historical equity risk off buffer in bonds being reset.
This is all theoretical but if you consider the 5-year interest rate expectations for central banks, a falling or at least flattening base rate is anticipated, particularly if inflation rates move back to target levels between 2-2.5%, When reducing rates, yields will naturally fall and bond prices will consequently rise. If this happens, it could be argued that meaningful capital gains can now be expected for investors with a reasonable investment time horizon. It’s important to remember that increased volatility has been a central feature within stock and bond markets over the last few years, so it is likely this may continue.
Source: JP Morgan Guide to the Markets
What about equities?
Equity markets have had it tough too. Rising interest rates in particular have contributed to the falling valuations. It’s probably fair to say the rally in certain tech and growth stocks during Covid was unsustainable, unjustified and extreme. The large debasing we’ve seen this year, although uncomfortable, has brought valuations down to more reasonable and interesting levels for stock pickers. Price to earnings ratios in developed markets now look favourable compared to averages since the 1990s. However, we’re yet to see how margin compression impacts on earnings. A lot of the pain seems to be priced in, but caution is wise. We may not have seen the end of declines just yet but equities look a lot more attractive now than they did at the beginning of the year.
Source: JP Morgan Guide to the Markets
What to expect?
Valuations across asset classes are far more attractive now than at the start of 2022. There has undoubtedly been a big valuation reset which may have further to go, but the opportunity is clearly more favourable for long-term investors.
The 60/40 portfolio has been violently shocked back to life and the deep sell off in bonds has perhaps managed to reset the risk off buffer it was previously heralded for. The historic and concurrent sell off in equities and bonds this year has highlighted that sometimes investors are thrown a curveball, but the importance of diversification remains arguably even more important moving forward.
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Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.