The 60/40 stock/bond portfolio, which has functioned for years as the standard for investors’ asset allocation, is under attack.
No less than three major firms have issued reports in the last few weeks declaring it dead or ailing: Bank of America Merrill Lynch, Morgan Stanley and JPMorgan.
The prime reason for shoving aside the 60/40 strategy is lower returns from bonds. Bonds not only deliver less yield in developed markets than they have historically — including negative yields in many European countries — but they also have less potential for capital gains because rates are already so low. The 10-year U.S. Treasury note is currently yielding 1.94%; the 10-year German bund, -0.25%.
“Lower returns from bonds create a challenge for investors in navigating the late-cycle economy,” according to JPMorgan’s latest Long-term Capital Market Assumptions report — its 24th — written by David Kelly, John Bilton and Pulkit Sharma. “The days of simply insulating exposure to risk assets with allocation to bonds are over.”
Bank of America Securities strategists Derek Harris and Jared Woodard, in a new report, “The End of 60/40,” explain that bonds have functioned as a hedge against stock losses because their returns have been negatively correlated to stocks. That negative correlation prevailed over the past 20 years — though not the previous 65 — but could flip as policy makers attempt to boost growth, according to Harris and Woodard.
Morgan Stanley’s cross asset strategists Serena Tang and Andrew Sheets attribute the decline of the 60/40 portfolio to not only low bond yields but also limited stock market returns, which in turn reflect lower income, low inflation expectations and penalties on both higher-than-average valuations and above-trend growth that cannot be sustained.
Sheets estimates that a 60/40 portfolio of U.S. stocks and government bonds will return just 4.1% a year over the next decade, close to the lowest expected return over the last 20 years.
JPMorgan strategists estimate a 5.4% annual return for a 60/40 portfolio over the next 20 years, but its portfolio includes global equities, U.S. corporate and U.S. investment grade corporate and high yield bonds.
Given this rather sobering outlook, JPMorgan strategists are calling for “greater flexibility in portfolio strategy and greater precision in executing that strategy.”
Among their recommendations:
- Corporate bonds which “continue to offer a decent return uplift,” though greater in shorter duration high yield rather than longer duration investment grade bonds.” But the strategists warn that “not much of a buffer is embedded in the credit complex were spreads to widen sharply during a period of economic weakness.”
- Emerging market equities and bonds. In local currencies emerging market stocks are forecast to return 300 basis points more than developed markets stocks while emerging market sovereign bonds and corporate bonds are forecast to return 5.9% and 4.9%, respectively, compared to 2.4% for 10-year U.S. Treasuries. In the short run, however, “the gearing to trade uncertainty presents a headwind.”
- U.S. real estate. This asset class has a low correlation to other assets, stable cash flows well above core government bond yields and a projected average annual return of 5.8% over the next 10 to 15 years.
- Private equity. This asset class “continues to be attractive to those investors looking for return uplift, as well as those seeking more specific exposure to technology themes,” according to JPMorgan strategists who are projecting 8.8% annual return over the next 10 to 15 years, up 55 basis points from their previous forecast. They caution, however, about the importance of manager selection.
- Infrastructure investment. “Increased demand for green projects supports infrastructure investment,” according to JPMorgan strategists. “Moreover, most green investments are likely to carry government guarantees, backed by tax receipts that can improve the quality of the cash flows and reduce the credit risks underlying these long-term projects.”
Even with these recommendations for alternative investments, JPMorgan strategists caution that “there is no single safe haven asset; rather, different assets protect against different risks, and their relative effectiveness and opportunity costs vary. Investors, too, vary — in the relative importance of the risks they need to protect against.”
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