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Weekly Investment Commentary: Market turmoil shines a light on 60/40 conundrum
Bottom line up top
- Pain and no gain. Investors seeking shelter from the first quarter’s harsh market and geopolitical maelstrom were frustrated at just about every turn. Major equity indexes tumbled into correction territory, and typically reliable sources of diversification failed to deliver their historical benefits amid broadly negative returns (Figure 1). While there were relative outperformers, even the best possible asset allocation outcome delivered results that were only “less worse.”
- Bonds break from the past. By any measure, the nearly 7% decline in the value of the 10-year Treasury in the first quarter was dismal on a historic scale. However, investors who focused on credit risk instead of duration risk (a stance we have been advocating for some time) were able to mitigate at least some losses. Figure 2 shows several rate-sensitive bond categories with elevated downside capture for the period, in uncharacteristic sympathy with falling equity markets.
- 60/40 portfolio bounce back? The first quarter was certainly challenging for the traditional 60% equity/40% fixed income portfolio. Focusing on the 40%, the key question is whether the pain is behind us or whether there’s more to come. We believe it’s the latter, with the Fed likely to maintain momentum and corporate fundamentals likely to remain strong. This further underscores our preference for credit assets (Figure 3).
Portfolio implications
History has not repeated. Comparing the 2022 market correction to history, the glaring difference is the performance of traditional fixed income. In the past, downside capture for bonds was negative or close to zero in most cases. But in 2022, we’ve seen positive downside capture, underscoring that we’re in a different regime. Another critical divergence from prior experience: Credit has offered more downside protection than duration.
“Focusing on shorter duration and taking on more credit risk has been a winning strategy so far this year. We expect that will continue.”
“Credit fundamentals remain strong, providing a further reason to be willing to take on credit risk.”
More fixing needed for the 40? Investors are likely asking whether the current posture that has been working (shorter duration, longer credit) will persist. Our answer is yes. We believe asset classes with significant duration exposure will continue to experience pain, so we still favor credit. Four reasons underlie this view:
- We don’t believe a recession is imminent (which would be the primary reason we’d feel compelled to prefer rates).
- The hiking cycle has only just begun.
- Inflation is high, and remains the focus of both the markets and the Fed.
- Credit fundamentals remain healthy (partially illustrated in Figure 3), backed by a strong economy.
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Regular meetings of the GIC lead to published outlooks that offer:
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Endnotes
Sources
All market and economic data from Bloomberg, FactSet and Morningstar.
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