New Year's Eve: The year the classic portfolio failed

The classic 60/40 portfolio lost about 17 per cent in 2022, a historic drawdown that left wealth managers and pension trustees with nowhere liquid to hide. For four decades the mix of equities and bonds was the default for institutional investors, and it rested on one assumption, that stocks and bonds move in opposite directions. When shares fell on corporate distress, money fled into government bonds, pushing yields down, lifting prices and cushioning the portfolio. In 2022 that diversification broke.

The hedge failed because of an inflation shock, and the arithmetic made the failure all but certain. When recessions come from weak demand, consumer prices fall, central banks can ease, and stocks and bonds move in opposite directions again.

Inflation changed the rules

When downturns come from supply shocks and runaway inflation, the central bank has to raise rates into a slowing economy. Higher discount rates then crush equity valuations and inflict heavy duration losses on bonds at the same time.

The correlation between stocks and bonds turned firmly positive, and the pairing that was meant to reduce risk compounded losses. Investors found that holding both simply gave them two ways to lose money to the same rise in discount rates.

How the year unfolded

The damage came from one source. The Federal Reserve lifted its policy rate by 4.25 percentage points over the year, from near zero to a range of 4.25-4.5 per cent, the fastest tightening since the early 1980s. The 10-year Treasury yield rose from about 1.5 per cent in January to nearly 4 per cent by December, and every other asset had to reprice against it.

The S&P 500 fell by about a fifth, its worst calendar year since 2008, and technology shares, whose value rests most heavily on distant profits, fared far worse. The Bloomberg US Aggregate bond index lost about 13 per cent, its worst year since the index began in the 1970s. A portfolio designed so that one half would cushion the other instead took losses on both at once, and in the worst months the bond half added to the losses instead of offsetting them.

A forty-year exception

The negative correlation that investors took for granted is younger than the 60/40 rule itself. For much of the period from the late 1960s to the late 1990s, stocks and bonds tended to rise and fall together, because inflation was the dominant risk and it hurt both. Only after inflation settled at low levels around the turn of the century did growth scares become the main threat, and bonds began to rally when shares fell.

The 1970s show what a portfolio of stocks and bonds does when inflation is volatile. Both lost heavily in real terms through the decade, and bonds in particular were derided by the end of it as certificates of confiscation. The investors who did best held real assets and short-dated instruments whose yields could rise with inflation.

Rebuilding the portfolio

The shift forces a thorough rethink of how multi-asset portfolios are built. While inflation stays volatile, bonds cannot be relied on to provide income and hedge equities at the same time.

Allocators are turning to real assets, commodities, trend-following funds and cash for the uncorrelated returns that government bonds failed to deliver. Commodities were among the few major asset classes to rise in 2022, and trend-following funds, which bet on persistent price moves in either direction, had one of their best years. Cash has become a real alternative for the first time in over a decade, with Treasury bills now yielding more than 4 per cent.

The biggest losers were strategies that leaned hardest on the old correlation. Risk-parity funds, which borrow to hold more bonds so that bond risk matches equity risk, suffered heavily. British pension funds using liability-driven investment were forced to sell gilts during the market turmoil of September, which showed how leverage built on a stable bond market can turn a price fall into a liquidity crisis.

The case for bonds now

The strongest argument against abandoning bonds is that 2022 has repaired their economics. A 10-year Treasury yielding nearly 4 per cent pays a real income again, and it has room to rally if the economy slips into the demand-driven recession that many forecasters expect. If inflation falls back, the old negative correlation could return quickly, and investors who sold bonds at the bottom would have locked in the loss.

That argument is sound as far as it goes. It depends on inflation settling near the Fed's 2 per cent target rather than at 3 or 4 per cent, and on the next downturn coming from weak demand rather than another supply shock. Neither is guaranteed, which is why allocators are adding other diversifiers instead of simply waiting for bonds to behave.

What would restore the hedge

The key indicator is the path of core inflation through 2023. If monthly core prices slow to a pace consistent with the Fed's target, the central bank can stop tightening, and bonds will again respond to growth scares by rallying. Market-based inflation expectations, measured by the gap between nominal and inflation-protected Treasury yields, will show whether investors believe that is happening.

The 60/40 collapse of 2022 showed that the stock-bond hedge was a product of forty years of falling inflation, and until inflation settles, pension funds that lean on bonds as their hedge will probably keep getting burned.