“The rumors of my death have been greatly exaggerated.”  – Mark Twain (1835-1910)

While returns on financial assets in 2022 left many investors frustrated, those holding balanced portfolios have reason to feel particularly aggrieved, having just experienced their worst year of returns since the Global Financial Crisis (GFC). Investors who hold balanced portfolios (typically a 60/40 allocation to stocks and bonds) generally do so because the strategy has, over time, yielded better risk-adjusted returns by limiting drawdowns versus equity-only strategies. The key tenet underlying the balanced approach is that stocks and bonds have historically tended to move in opposite directions during times of financial market stress.

The 60/40 portfolio boasts an impressive track record: Prior to 2022, it delivered positive returns in 35 of the previous 41 years. But in 2022, the strategy didn’t work as investors have come to expect, recording a -16.9% return as the Bloomberg U.S. Aggregate Bond Index (U.S. Agg) logged its worst year on record, and the S&P 500^® Index simultaneously experienced its seventh-worst year since the Great Depression.

Naturally, many investors have started to question whether the game is up, and if traditional stock-bond diversification is dead? Has the multi-decade symbiotic relationship between stocks and bonds come to a bitter and abrupt end?

Returns: 2022 was a rarity

In our view, it is vital for investors to grasp how rare 2022 was from a return perspective. Much of the move down in asset prices was triggered by the Federal Reserve’s (Fed) aggressive rate hikes (4.25% within the calendar year) as it sought to rein in runaway inflation. But, as shown in Figure 1, the combined effect of the rate hikes on stocks and bonds was highly unusual, as they both ended the year down for only the fifth time since 1928.

Correlations: 2022 was not that unusual

As the debate over the balanced portfolio’s future rages on, critics of the 60/40 portfolio have pointed to the sharp increase in the correlation between stock and bond returns in 2022. Their argument? If bonds and stocks are now moving in lockstep with one another, of what use are bonds as a diversifier? In our view, however, investors would do well to consider a longer-term view of correlation. As shown in Figure 2, over the past 30 years, stock-bond correlations have fluctuated significantly on a 1-year rolling basis, and on a 3-year rolling basis have remained either positive or negative for long periods of time. Yet, despite the short-term swings, stock-bond correlation has on average been close to zero. It is not unusual for correlations to rise over the short term and, as such, we do not see evidence to substantiate a theory that the fundamental relationship between stocks and bonds has broken down.

Reflecting and moving forward

As investors pause to evaluate their portfolio performance in 2022 and chart their course for 2023, we believe there are two key points to consider.

First, investors should keep 2022 in perspective. The markets experienced a significant repricing of risk by way of higher interest rates, and while it was painful to go through, one should be careful not to misinterpret a single year as a change in a long-term relationship. We would advocate against making any large or sudden moves in reaction to what happened in 2022; rather, we believe investors should only adjust their asset allocation in response to a change in their long-term goals or risk tolerance. Bad years do happen; that’s simply the nature of putting capital to work. But tough years can help guide investors toward self-reflection and a re-evaluation of their investment objectives to ensure their allocation is the right one for the long term. Additionally, for investors in 60/40 portfolios lamenting the losses from 2022, it is important to note that balanced portfolios have historically recovered sooner than equity-only portfolios, as shown in Figure 3.

Second, we think investors should be forward looking in their portfolio positioning. The silver lining from 2022 is that both equities and bonds are in a much better place now than they were a year ago. For fixed income, as inflation continues to trend downward, we believe most of the increase in rates is behind us. After many years of zero-policy rates, investors are finally getting income from their fixed income allocations, as bonds are now offering some of the most attractive yields since the GFC. Additionally, in our view, fixed income is better positioned to provide much-needed diversification and serve as a ballast in portfolios should economic conditions worsen in the year ahead.

As for equities, multiples now appear to be in a more reasonable range, and we think the reset in valuations has created opportunities. Prior to the Fed’s policy tightening in 2022, inexpensive capital broadly supported all companies, whereas the new environment could favor a more active approach and individual stock picking. Rather than broad groups of stocks leading based on general trends or factors, we believe relative performance will be more dependent on dynamics at the individual company level. In this market, we think innovation in products and services, effective capital allocation, and management’s ability to contain costs and gain productivity from resources (both physical resources and labor) as well as the skill to utilize capacity at efficient levels will all be integral in determining companies’ growth.

Adding active and dynamic management to the 60/40 construct

In summary, we believe that an active, dynamic approach to managing a balanced portfolio may prove beneficial in the years ahead. We think tighter monetary policy could favor a more active approach within each asset class, with opportunities for active managers to pick individual stocks and bonds with superior cash flow and balance sheet metrics.

Similarly, we think investors might benefit from managers that have somewhat flexible mandates to dynamically adjust a portfolio around the 60/40 mix instead of being too tightly bound to the benchmark allocation. This flexible approach can seek to take advantage of relative value opportunities between stocks and bonds while still benefitting from the 60/40 portfolio’s structural advantages.