The “60/40 portfolio” (60% stocks, 40% bonds) suffered a historically bad run in 2022, prompting many market practitioners to the 60/40 portfolio construct dead? With the stock/bond correlation rising sharply in just a few months, the diversification benefits and alpha potential of the 60/40 dwindled, hurting both the strategic construct and tactical asset allocation of multi-asset portfolios. Fixed income yields were hovering near historic lows, providing limited cushion for 60/40 portfolios against losses in equities, especially as it was accompanied by rising interest rates. Yet, an examination of inflation and growth dynamics suggests that the elevated stock/bond correlation is likely temporary and should normalize lower as inflation stabilizes. Lowered stock/bond correlation and higher fixed income yields suggest that the fundamental construct of the 60/40 portfolio remains attractive.

Diminishing diversification benefits

60/40 portfolios have delivered 9.4% annual returns over the last five decades, only marginally below the S&P 500’s 10.9% return, but with much lower volatilities. For investors with a more limited risk budget, or for those who sought out a potentially more consistent investment experience, the 60/40 portfolio has been quite an attractive option. Why has the 60/40 portfolio historically offered better risk-adjusted returns than the S&P 500? The diversification benefit—which is mainly driven by low stock/bond correlations.1 When stock/bond correlations are low, the diversification benefit is high, and vice-versa.

Since 1973, there have been five instances when the S&P 500 delivered an annual loss of more than 10%—the 60/40 portfolio outperformed the S&P 500 in each instance. In 2022, however, with heightened stock/bond correlations, the returns of equities and fixed income fell in tandem amid market meltdowns. Combined with already low starting bond yields, this created an environment where, despite still outperforming the S&P 500, the 60/40 portfolio recorded its second-largest annual loss since 1973.

Performance divergence when equity drawdown is greater than 10%
60/40 versus S&P 500

Bar char of 60/40 vs. S&P 500 comparing performance divergence when equity drawdown is greater than 10%.

Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022. Inception date: January 31, 1973. Strategic Allocation: 60% S&P 500, 40% Bloomberg U.S. Treasury. Returns are gross and in USD without taking any without taking any transaction cost and alpha assumptions into accounts. Portfolio is rebalanced to the target weight on a monthly basis. Past performance is not an indicator of future performance. Not to be taken as investment advice. Actual returns may vary significantly from modelled returns.

Unsurprisingly, 2022’s abysmal performance has raised the chorus of “the death of the 60/40 portfolio,” with investors concerned that multi-asset portfolios’ stability benefits and the asset allocation alpha potential are significantly and fundamentally reduced. What made this statement popular was the low yield environment preceding the 2022 selloff, and some market participants’ belief that the recent inflation increase was a regime shift that would permanently increase stock/bond correlations. Before concluding that the 60/40 portfolio is dead however, it’s important to examine the stock/bond correlation drivers for better insight into whether the recent correlation rise is a temporary or long-term structural shift.

Stock/bond correlation and diversification benefits

Line graph of stock/bond correlation and diversification benefits from 1976-2023.

Note: Correlations are between S&P 500 and Bloomberg UST Index. Diversification benefits defined as volatility reduction of 60/40 portfolio.
Source: Bloomberg, Principal Asset Allocation. Data as of June 30, 2023.

Stock/bond correlation dynamics

Although stock and bond performance are subject to many different forces, the two most important macro factors are economic growth and inflation. These two factors work differently for stocks and bonds, shaping their correlation landscape over time.

In a simplified model, when an economy grows rapidly, stocks typically benefit from stronger corporate earnings and higher dividends and therefore deliver better returns. Strong economic growth, however, leads to higher bond yields, which causes bonds to underperform. Alternatively, when inflation is high, central banks are typically raising interest rates to increase funding costs and curb demand, which is detrimental for both stocks and bonds. Effectively, economic growth moves stock and bond prices in opposite directions, while inflation, whether positive or negative, moves stock and bond prices in the same direction.

Using industrial production as a proxy for growth and consumer prices as a proxy for inflation, data from the last five decades (January 1973 – May 2023) shows that for every 1% increase in economic growth, stocks rose by 1.1% and U.S. Treasury bonds fell by 0.3%. By contrast, for every 1% increase in inflation, stocks fell by 0.5% and U.S. Treasury bonds fell by 0.2%.

Historic trends

Before the 2000s, particularly in the ’70s and ’80s, inflation and interest rates were considerably more volatile. Large swings in inflation and rates played a more significant role in determining various assets’ performance and resulted in higher correlations and lower diversification benefits. In contrast, the inflation and rate environments were more stable from the late 1990s to 2010s, which made economic growth cycles more important to asset class performance, lowering stock/bond correlations.

The economic environment of 2020-2022, with its large swings in inflation and rates, resembles the ’70s-’80s period more than the last two decades. Consider: The COVID crisis led to a short deflation period, with Fed funds rates cut to zero in one month. A strong recovery and quick rebound in aggregate demand followed. By 2021, with inflation skyrocketing, the Federal Reserve (Fed) chose to respond in force, and since March 2022, investors have witnessed the most aggressive Fed hiking cycle since the late 1980s, with 500 bps of rate increases in 15 months. Given the characteristics of the 60/40 portfolio, these swings resulted in rising correlations, stocks and bonds falling together, and drove 60/40 performance to a near-historic low.

Stock/bond correlation versus U.S. inflation
By decade, 1970–present

Bar chart of stock/bond correlation vs. U.S. inflation from 1970-2023 by decade.

Note: Correlations are between S&P 500 and Bloomberg UST Index.
Source: Bloomberg, Principal Asset Allocation. Data as of June 30, 2023.

The path forward

Since late 2022, both flexible and sticky components of U.S. inflation are trending lower, despite the sticky components proving slow to normalize. Easing supply chain bottlenecks, lower commodity prices, and the weakening economic growth outlook are all weighing on consumer prices. Given that the drivers of inflation's rapid increase over the last two years are unlikely to repeat, investors should expect a more stable inflation environment ahead.

Flexible versus sticky inflation
3-month annualized rate, 2001–present

Line graph comparing flexibly and sticky inflation from 2001-2023 at a 3-month annualized rate.

Source: Atlanta Fed, Bloomberg, Principal Asset Management. Data as of June 30, 2023.

Receding inflation and the Fed approaching the end of its hiking cycle suggest the macro environment will likely put downward pressure on stock/bond correlations. Indeed, the uncertainty around the growth outlook presents a challenging environment for investors, illustrated by market expectations jumping between hard landing and soft-landing scenarios during the first half of 2023. As a result, stock/bond correlations have started to fall—adding fuel to the argument that 2021-2022 was an anomaly rather than a permanent shift in the correlation regime.

Thanks to higher interest rates, investors are getting much higher compensation for taking interest rate risk compared to 2021-2022. Bond yields are now much higher, providing better carry (income) and a cushion for potential future losses in bond prices. The higher carry currently offered by bonds increases the utility of bonds in a 60/40 portfolio, as it provides mitigation against losses in equities.

In short, the demise of the 60/40 portfolio seems overly exaggerated, and the higher stock/bond correlations in 2022 appear to have been more of a speed bump than a permanent shift in trajectory. In fact, since the market shock in 2022, falling stock/bond correlations combined with the highest bond yields since the Global Financial Crisis have restored the 60/40 multi-asset portfolio construct back to its historical reputation as an appealing option for investors seeking risk-adjusted returns.

1 The diversification benefit can be defined as the percentage reduction in the volatility by a 60/40 portfolio compared to weighted average of equity and fixed income volatilities. It manifests in the way that 60/40 portfolios typically lose less during market drawdowns.

Asset allocation
Fixed income

Risk considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options.

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