Analysis-Investors count on bonds to rescue battered 60/40 portfolio in 2023

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By David Randall

NEW YORK (Reuters) - Proponents of the so-called 60-40 portfolio are betting the strategy may soften the blow of a possible U.S. recession next year, though its much-touted diversification properties offered investors little relief in 2022.

A 60/40 portfolio, which typically allocates 60% of assets into stocks and 40% into bonds, counts on moves in the two asset classes to offset one another, with stocks strengthening amid economic optimism and bonds rising during uncertain times.

The strategy went awry in 2022, as the Federal Reserve raised interest rates to fight the worst bout of inflation since the early 1980s, sparking sharp declines in both asset classes. A 60/40 split between the S&P 500 index and the Bloomberg Bond Aggregate Index is down 12.4% so far this year, headed for its worst annual performance since 2008, according to Vanguard.

"The degree of correlation that we've seen this year is extreme, and the pain that people have felt has been extreme," said Luke Barrs, global head of fundamental equity client portfolio management at Goldman Sachs (NYSE:GS) Asset Management.

GRAPHIC: Diversified portfolio returns since 1977 (https://fingfx.thomsonreuters.com/gfx/mkt/zdvxddabavx/Pasted%20image%201671485917679.png)

Advocates of the strategy believe it is more likely to work in the coming year, with its fixed income component doing the heavy lifting if the Fed's monetary policy tightening brings on a recession - an outcome that has increasingly worried Wall Street.

Though market participants tend to avoid bonds during inflationary times, they are a popular destination for haven-seeking investors when the economy wobbles. Some also believe a downturn will push the U.S. central bank to cut interest rates earlier than intended, though policymakers last week projected another 75 basis points of increases next year. Falling rates would pull down bond yields, which move inversely to prices.

"If we have a recession, and I think there's a very good chance of that, you will see rates decline and you'll have capital gains in bonds," said Lewis Altfest, head of Altfest Personal Wealth Management, which oversees some $1.4 billion in assets.

The sharp fall in bonds has also boosted their attractiveness to some investors. The ICE (NYSE:ICE) BofA US Treasury Index is down 11% this year and on track for its largest fall on record, while the benchmark U.S. 10-year Treasury yield stands at around 3.7%, up from 1.49% at the start of 2022.

"The bond market ... now has the opportunity to give you the potential for diversification because there's a chance for rates to go down," said Jeffrey Sherman, DoubleLine's deputy chief investment officer.

While this year's lockstep moves in stocks and bonds were spurred by soaring consumer prices, such an inflationary shock is unlikely to recur in 2023, said Roger Aliaga-Diaz, chief economist for the Americas and global head of portfolio construction at Vanguard. U.S. inflation fell for a second straight month in November, spurring hopes it may be on a sustainable downward trend.

Consecutive annual declines in the 60/40 portfolio have been rare. Since 1977, U.S. 60/40 portfolios only notched consecutive losses in a three-year stretch from 2000 to 2002, during which the strategy lost a total of 25%, Vanguard's data showed.

DON'T FIGHT THE FED

Of course, betting on lower rates and a speedy decline in inflation puts investors at odds with Fed projections, which last week showed policymakers expect the central bank's benchmark overnight interest rate will need to rise next year to a higher level than previously anticipated to fight stubborn price pressures. Higher-than-expected borrowing costs or rebounding inflation could deal another blow to investors in both stocks and bonds.

"Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation," strategists at the BlackRock (NYSE:BLK) Investment Institute warned in their 2023 outlook. "If anything, policy rates may stay higher for longer than the market is expecting."

And while Vanguard and other 60/40 proponents say the selloff in stocks has made the portfolio's equity side more attractive due to falling valuations, a recession could hit earnings and further weigh on shares.

The S&P 500 has fallen by an average of 28% in recessions since World War Two, data from CFRA showed, though some argue this year's tumble - which hit 25.2% in October - suggests equities have at least partially factored in a slowdown. The S&P 500 is down about 20% on a year-to-date basis.

Still, Jason Pride, chief investment officer of private wealth at Glenmede, believes deep declines have increased the strategy's attractiveness over the long term.

"For the next 10 years 60/40 portfolios are at a lot better starting place than they have been in years, and that's in large part because bonds are in a very favorable position," he said.