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The Debate Over 60/40 Portfolios: The Fed’s Role in Distorting Capital Market Pricing

By Nick Sargen
Economics Markets Wealth Management
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The portfolio mix of 60% stocks and 40% bonds has been one of the most popular asset allocation strategies since Harry Markowitz developed modern portfolio theory. Markowitz’s formulation of the efficient frontier allows investors to trade off risk-tolerance and reward-expectations to derive an optimal portfolio. So, is the 60/40 portfolio allocation still the right balance?

What has made a 60/40 portfolio mix appealing is correlations between stocks and bonds are usually low and at times they have been negative (see chart below). Over the past two decades, for example, bond prices typically rose (and interest rates fell) when the stock market sold off.

10 year rolling correlation of S&P 500 to US Aggregate Bond Index (1976-2022)

Stock and Bond Prices Plummeted in 2022

This was not the case last year, however, as both stock and bond prices plummeted. The catalyst was a surge in inflation to a four-decade high that resulted in the Federal Reserve raising the federal funds rate by 450 basis points. As yields rose, the bond market posted its worst showing on record, according to economic historian Edward McQuarrie of Santa Clara University, with the Barclays Aggregate index returning minus 13%.

With returns for the S&P 500 index also down by 18%, the return for a 60/40 portfolio was minus 15% last year. Through the first three quarters, moreover, the portfolio return was negative 20%—the third worst showing in the last 100 years and the worst result on record in real (inflation-adjusted) terms.

Experts Take Opposite Sides in the 60/40 Debate

This outcome has added fuel to a debate about whether the traditional 60/40 portfolio mix is still relevant. An article by James Mackintosh of The Wall Street Journal notes that two of the best-known firms in asset management are taking opposite sides in the debate. BlackRock says the portfolio losses last year show that the structure is outdated, while Goldman argues that the rare big-loss is inevitable for any strategy.

The crux of the difference in views is whether there has been a structural shift in the economy. Goldman calculates that U.S. stocks and bonds both lost money over a 12-month period just 2% of the time since 1926, and it maintains an investor should only change the strategic allocation if there has been a structural change in the economic landscape. BlackRock bases its case exactly on this premise—namely, it maintains the period of low inflation and steady growth dubbed “The Great Moderation” is over.

The Fed Played a Key Role in Distorting Capital Market Pricing and Investment Returns

This debate, however, does not highlight the key role the Federal Reserve played in distorting capital market pricing and investment returns for the past 15 years. The Fed responded to the housing bust and financial crisis in 2008 by lowering the funds rate to zero and introducing quantitative easing, in which it quadrupled its balance sheet to keep bond yields artificially low. While the Fed began to normalize policy in 2017-2019, it subsequently reversed course when the COVID-19 pandemic struck, and it reinstated zero interest rates and undertook another quadrupling of its balance sheet.


Artificially Low Interest Rates Created Bubbles

As a result, U.S. interest rates were artificially low throughout this period. This had two discernable effects on investors. First, it discouraged investors who were seeking stable income sources from holding bonds or bank deposits, and it encouraged them to seek out higher-yielding instruments. This was the genesis for investors questioning whether bonds still provided an adequate earnings stream that was predictable.

Second, artificially low interest rates also prompted investors to seek out equities and other higher-risk assets to boost portfolio returns. They contributed to asset bubbles in housing and equities during the mid-2000s that burst in 2007-08. Thereafter, the S&P 500 index rose more than five-fold from the beginning of 2009 to the start of 2022. What ensued last year was merely payback for both stocks and bonds being considerably over-valued.

2023 Outlook for Stocks and Bonds

As a recent Morningstar report maintains, it would be a mistake for investors to alter their strategic asset allocation now because of one very bad year. Valuations in the bond market and stock market are much closer to their long-term norms than they were a year ago. There is also mounting evidence that inflation has peaked and will be significantly lower than last year, which should buttress bond returns. Equity valuations should also fare better this year, but the outlook for stocks hinges on whether there is a recession and, if so, how long and deep it will be.

Investment Strategies Will Hinge on Fed's Actions

The case for reconsidering one’s tactical asset allocation depends on how the Fed will respond to an environment of little growth and inflation that is above its 2% annual target. If the Fed were to raise the funds rate to 5% or more and then pause, bonds would likely rally while stocks would stay volatile. Conversely, if the Fed eased policy as unemployment worsened, stocks would likely rally initially.

What matters over the long-term, however, is whether investors retain confidence in the Fed’s commitment to bring inflation under control. If it does, both stocks and bonds stand to benefit, although returns would likely be lower than in the past two decades.  

Conversely, if the Fed waivers in its commitment and inflation expectations become entrenched, investment portfolios are likely to suffer as they did in the 1970s. In this respect, the key issue for investment strategy going forward is whether the Fed will pursue traditional policies or revert to unorthodox policies that distort capital markets.


A version of this article was posted to Forbes.com on February 1, 2023.

This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Opinions expressed in this commentary reflect subjective judgments of the author based on the current market conditions at the time of writing and are subject to change without notice. Information and statistics contained herein have been obtained from sources believed to reliable but are not guaranteed to be accurate or complete. Past performance is not indicative of future results. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission of Fort Washington Investment Advisors, Inc.

nick sargen

Nick Sargen

Senior Economic Advisor
Nick is an international economist, global money manager, author, and contributor on television business news programs. He earned a PhD and MA from Stanford University and BA from UC, Berkeley.

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