A hot topic for investors in 2022 has been the weak year-to-date performance of the 60/40 portfolio, which involves allocating a portfolio to 60% stocks and 40% bonds. The basic idea is that allocating to bonds will reduce overall portfolio volatility, while also providing a buffer against drawdowns in the equity market. However, as of June 14, an investor with a 60% allocation to the S&P 500 Index and a 40% allocation to the Bloomberg U.S. Aggregate Bond Index would be experiencing a loss of 18.2%.
If return expectations were calculated using the average return correlation from the last 20 years of -9.0%, the expected loss on the portfolio would have been 12.3%. This large discrepancy begs the question — what is happening? In today’s Chart of the Week, I will attempt to put the correlation between stock and bond returns, a large driver of the protective benefits the 60/40 portfolio is intended to provide, into historical context.
This week’s chart presents the correlation between the total returns of the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index, calculated on monthly data, from January 1976 until May 2022. Correlations are calculated using a rolling 36-month window, allowing three years of monthly data to be considered at a time. This method was chosen in order to reflect the relatively long-term bias of 60/40 investors. A similar correlation pattern is seen in the data if shorter or longer windows are chosen.
The chart depicts two clear correlation regimes throughout time. Before the year 2000, the correlation between stocks and bonds was persistently positive. Beginning in 2000, we entered a 20-year period of persistently negative correlations, with some brief forays into positive territory. This 20-year period saw the rise of the 60/40 portfolio as a popular long-term asset allocation strategy. Interestingly, beginning in 2021, correlations have become persistently positive again.
The two-decade-long period between 2000 and 2020 provided the perfect environment for the 60/40 portfolio to prosper. Besides a detour into positive territory between 2009 and 2012, driven by the 2007-08 Great Financial Crisis, stock and bond returns were negatively correlated for long stretches of time. This allowed the bond allocation to serve both of its purposes for the portfolio, dampening volatility and protecting against drawdowns.
I would argue that the monetary policy of this era had a great impact on this relationship. Beginning with Federal Reserve (Fed) Chair Alan Greenspan, investors came to rely on the Fed Put. During times of equity market stress, it was widely expected that the Fed would step in to ease financial conditions with lower interest rates and quantitative easing. This allowed bond prices to appreciate as equity prices declined, resulting in negative correlations between stock and bond returns. At the same time, long periods of low bond yields contributed to a view that there were no alternatives to equities. This sentiment caused the selling of bonds and buying of equities, further fueling the negative correlation.
Examining the left side of the chart, a different story can be told. The 1970s were characterized by stagflation, a condition simultaneously featuring high inflation and stagnant economic growth. This was mainly driven by skyrocketing prices of energy, coupled with loose monetary and fiscal policies. In 1979, Paul Volcker became chairman of the Fed and made clear that his primary focus would be crushing the inflation that had become ingrained in the economy.
This led to a period of aggressive interest rate hikes and general tightening of financial conditions. The tightness throughout the economy resulted in a period of greater volatility for financial assets and contributed to positive correlation between stock and bond returns. Namely, increasing interest rates led to lower bond and equity prices, due to rising yields on bonds and a reduction in forward-looking earnings measures that utilize present values of cash flows.
In this environment, the bond allocation in the 60/40 portfolio does not fully serve its intended purpose. Positive correlations actually serve to increase portfolio volatility and result in drawdowns above expectations. Rather than serving as a diversifying hedge, adding a bond allocation to an equity portfolio can increase portfolio risk in a positive correlation regime.
This year, we have seen a positive correlation between stock and bond returns contribute to an eye-popping drawdown compared to what 60/40 investors have grown accustomed to over the past 20 years. There are some historical parallels between this environment and the last time we experienced a positive correlation regime between stocks and bonds.
Namely, inflation is way above the Fed’s target and continues to increase after a prolonged period of loose financial conditions, coupled with massive fiscal stimulus. This has led to the Fed signaling it is committed to materially tightening financial conditions. Last week, the Fed hiked rates 75 basis points at a meeting for the first time since 1994. At the same time, we have recently seen the World Bank slash growth forecasts across the globe and issue a warning about the risk of stagflation.
In addition, we have experienced heightened volatility in both equity and bond markets as investors try to correctly price Fed actions and global economic conditions. Historically, these factors have contributed to the positive correlation regime we have been experiencing recently. However, parallels can also be drawn to the dot-com bubble, with the recent massive run up of all things tech. Like the dot-com bubble, the underlying value of many of these companies mattered little to investors seeking growth, resulting in massive valuations for companies unable to turn a profit.
The popping of this bubble led to easier monetary policy and a negative correlation regime. It is too early in the current monetary-tightening cycle to forecast whether we will sustain this positive correlation regime long term, but it seems the path of monetary policy may hold the key to an answer.
Key Takeaway
There is a saying I like: “History doesn’t repeat itself, but it often rhymes.” I believe that in light of the current market environment, it is prudent to examine whether the protective benefits of the bond allocation in the 60/40 portfolio are fully available to investors in different market environments. In the past, we have seen regimes of positive correlation between stock and bond returns, which dampens the protective benefits of a bond allocation in a portfolio.
If Chair Powell has his “Volcker moment” and embarks on a path of demand destruction to rein in inflation, it is plausible the positive correlations between stock and bond returns we have seen this year are here to stay. In this case, investors should be prepared to be more tactical when searching for uncorrelated asset classes to add protection to long-term allocations, as the protective benefits of bonds may be weaker than we have grown accustomed to. However, if the Fed Put still exists in this cycle, we may see this period as temporary pain for the 60/40 allocation and return to the status quo of the past two decades.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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