Stock-bond correlation and 60/40 portfolio are at crossroads
In 2022 the diversification between stocks and bonds within a "60/40" portfolio was an ineffective strategy that yielded negative returns and, as a result, did not safeguard the investment.
The reason was that both equities and bonds plummeted in lockstep as a result of the Federal Reserve's interest rate rises, with the correlation reaching its highest level in a decade. The blue area in chart above shows the 60-day rolling correlation coefficient between the S&P 500 index (
SPX
) and the Vanguard Total Bond Market (
BND
) ETF, which currently stands at 0.89.
The positive stock-bond correlation had typically worked when the two assets climbed upward together in the post-GFC decade, but in this new environment, it did the opposite and for a longer time than in 2008 and 2020.
Similar to 2008-2009, a 60/40 portfolio of global equities and bonds saw a maximum drawdown of 25% this year, but lasted more.
The fall from peak to trough of the 60/40 portfolio lasted 252 days between June 2008 and March 2009, just 35 days between February and March 2020, and 336 days in 2022, making it the longest 60/40 bear market in the past two decades.
60/40 portfolio and its drawdowns – 60% Vanguard Total Stock Market ETF (
VTI
) & 40% Vanguard Total Bond Market ETF (
BND
)
As we approach the final FOMC meeting of 2022, the future of bonds and stocks is at a crossroads, and a decoupling between the two assets may occur, making the 60/40 portfolio diversification plan more effective moving into 2023.
If the Fed signals that the end of the hike cycle is nearing and adopts a more dovish stance on inflation, both stocks and bonds will benefit from here.
If the Fed indicates that interest rates will continue to increase and that the window for a soft landing is narrowing, bonds will outperform stocks. However, equities will receive a boost when the recession comes and the Fed is pressured to cut interest rates.
The downside risk of this approach is an excessive tightening of interest rates by the Fed, which might increase bond yields even more (and cause prices to drop) and further devalue equity markets, extending the bear market for the 60/40 portfolio.
The reason was that both equities and bonds plummeted in lockstep as a result of the Federal Reserve's interest rate rises, with the correlation reaching its highest level in a decade. The blue area in chart above shows the 60-day rolling correlation coefficient between the S&P 500 index (
SPX
) and the Vanguard Total Bond Market (
BND
) ETF, which currently stands at 0.89. The positive stock-bond correlation had typically worked when the two assets climbed upward together in the post-GFC decade, but in this new environment, it did the opposite and for a longer time than in 2008 and 2020.
Similar to 2008-2009, a 60/40 portfolio of global equities and bonds saw a maximum drawdown of 25% this year, but lasted more.
The fall from peak to trough of the 60/40 portfolio lasted 252 days between June 2008 and March 2009, just 35 days between February and March 2020, and 336 days in 2022, making it the longest 60/40 bear market in the past two decades.
60/40 portfolio and its drawdowns – 60% Vanguard Total Stock Market ETF (
VTI
) & 40% Vanguard Total Bond Market ETF (
BND
)
As we approach the final FOMC meeting of 2022, the future of bonds and stocks is at a crossroads, and a decoupling between the two assets may occur, making the 60/40 portfolio diversification plan more effective moving into 2023.
If the Fed signals that the end of the hike cycle is nearing and adopts a more dovish stance on inflation, both stocks and bonds will benefit from here.
If the Fed indicates that interest rates will continue to increase and that the window for a soft landing is narrowing, bonds will outperform stocks. However, equities will receive a boost when the recession comes and the Fed is pressured to cut interest rates.
The downside risk of this approach is an excessive tightening of interest rates by the Fed, which might increase bond yields even more (and cause prices to drop) and further devalue equity markets, extending the bear market for the 60/40 portfolio.