In the 60/40 dead?

   By Guest Blogger Ryan Lewenza

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Readers of this pathetic blog know that we have chiseled abs (well Garth anyways), prefer dogs to cats, and to our core believe in balanced 60/40 investment portfolios. The thinking is pretty simple. We invest 60% in growth assets (i.e., stocks) and 40% in safer things (i.e., fixed income). Through this mix of stocks and bonds we’re able to generate decent portfolio returns while minimizing portfolio volatility.

For decades now this strategy has been a big winner producing returns of 7-8% annually before fees. However, there are some now calling for the end of the 60/40 balanced portfolio with interest rates hovering near all-time lows. Bank of America was one of the first large US banks to make this bold prediction in their report “The End of 60/40”, with other firms like JP Morgan piling on to this investment thesis. In this week’s post I push back against their criticisms and remind readers why we believe the 60/40 portfolio is still the way to go.

Reading through some of these reports the key points to why the 60/40 is dead in their view are: 1) with interest rates at record lows there is only one way to go and that’s up, which would result in negative returns on bonds; and 2) the long-term negative correlation between bonds and stocks will begin to break down, thus bonds losing their portfolio hedging characteristics in downturns.

Let’s begin with the first point: bond yields are destined to rise resulting in negative returns from bonds in the years ahead.

Below is a very long-term chart of the Government of Canada 30-year bond yield and you can see how it has declined steadily since the early 1980s from 18% to just 1.4% today. So the simple thinking is we’re at record lows and they can only go up from here. But can they?

Long-term Chart of GoC 30-Year Bond Yield

Source: Bloomberg, Turner Investments

For some years now I’ve been in the lower-for-longer camp with respect to interest rates. In fact, I believe developed regions like the US, Canada and Europe will experience a similar fate as Japan where interest rates could remain stubbornly low for years if not decades. Here’s why.

First, the long-term drivers of economic growth are population growth and productivity gains, which are both on the decline. We’re just not producing enough babies these days (that’s one reason why immigration is so important). For example, US population growth has slowed from 1.7% annually in the 1960s to just 0.7% today. Similarly, productivity gains continue to diminish, so as these drivers decline so should economic growth. Historically, the US economy has grown an average of 3.3% annually, but I see this downshifting closer to 2% due to these macro trends. If correct, this lower economic growth should keep interest rates well anchored around these low historical levels.

Second, governments simply can’t afford higher interest rates given all the debt in the world. At last check the US has US$22 trillion in debt outstanding. If interest rates were to rise meaningfully the interest expense would skyrocket, which would put huge pressure on the US government’s balance sheet, and either lead to higher taxes and/or large spending cuts. In short, rates can’t rise materially or we’re all screwed.

US Government Debt is at US$22 trillion

Source: Bloomberg, Turner Investments

So, given I see interest rates staying lower-for-longer, I don’t see major losses from bonds in the coming years. Now I don’t see major returns either, which is why we view bonds more as a shock absorber for portfolios rather than counting on them for gains.

The reason we continue to view bonds as a shock absorber in portfolios is their negative correlation with stock prices. The can be seen visually in the chart below.

I show the rolling correlation of US Treasury bond and stock prices. For over two decades now the correlation has been negative (currently -57%) between the two, which in laymen terms means that when stocks decline bonds move higher and vice versa. This is critically why we continue to recommend investors hold high-quality bonds. And, given I see government bond yields remaining lower-for-longer, I see this relationship continuing to hold.

Correlation of US Treasuries and S&P 500

Source: Bloomberg, Turner Investments

Finally, while I disagree with BoA and other firms that the 60/40 is dead, I do agree with them that in this low interest rate environment we need to adjust portfolios to make up for the lost income from government bonds. We do this by including more corporate bonds, which pay higher yields, dividend-paying stocks and preferred shares.

In fact, preferred shares provide a great hedge in case we’re wrong about interest rates remaining low. If BoA turns out to be correct, and rates move materially higher, then our preferred share ETF will greatly benefit from this, as preferreds do well in a rising rate environment. And this hits home an important point: from time to time some of our calls will not work out and this is why we structure the portfolio using a mix of bonds, preferred shares and stocks. Each one is driven by different factors and by including a mix of these different assets it ensures we always have something that is working even if something else is not, and this is how we’re able to provide fairly consistent long-term returns for our clients.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.