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February 2023

Market Update: History Supports Optimism for 60/40 Portfolios

Key Points

  • Very difficult year unlikely to be repeated
  • But remain cautious near term
  • Higher for longer outlook still unfolding

2022 was one of the most challenging years in my many decades of investing. For the first time in history, stocks and bonds both declined by more than 10%. This highly unusual combination resulted in the traditional 60/40 portfolio — designed to offer a degree of downside protection in turbulent markets — posting an eye-watering 16.9% decline and its worst annual return since the Great Financial Crisis of 2008. We believe 2023 will ultimately turn out to be more positive for investors but remain cautious for now.

Looking closer at historical performance, we see good reason for optimism going forward. Since 1926, there have been only six years where the 60/40 portfolio mix has declined by 10% or more, and cumulative returns were higher in most cases six months later and significantly higher after one year and three years.

The real shocker though in 2022 was that bonds fell for the second year in a row, with their 13% decline the biggest in nearly 100 years. Prior to this, the most bonds declined in a given year was in the 6%–7% range, and this occurred only three times, with the average next year return for fixed income investors a very strong 8%.

So with history on our side, where do we go from here? The good news, after such a painful experience, is that the outlook for the year ahead is considerably brighter. However, we think investors will first likely need to exercise a bit more patience. From our perch, we see 2023 shaping up to be a tale of two halves, with the many factors that have weighed on markets this past year — persistently strong inflation, hawkish central banks, rising recession risk and ongoing geopolitical uncertainty — continuing before giving way to more favorable market conditions. Until then, there are several key issues we are watching.

At the top of our list is the path of Fed policy. While inflation trends are now moving favorably, they are likely happening too slowly for central bank officials. With wage and service sector pressures in particular proving stubborn, the Fed has continued to signal it plans to “hike and hold” rates at high levels. Investors, though aren’t buying it, with the market’s rally off its mid-October low premised on expectations that officials will pivot to cutting rates as soon as the second half of 2023. However, if as we expect, the Fed does stay on course keeping rates higher for longer, further volatility in the months ahead is likely.

Indeed, given the Fed’s determination to bring down inflation, a recession in coming months will be hard to avoid. Higher rates have already taken a significant bite out of economic activity, and due to the lagged nature of monetary policy transmission, the full effects of tightening have not yet been felt on the economy. From an investment perspective, what concerns us the most is that markets still seem to be pricing in a soft landing ahead, with 2023 earnings growth expectations a relatively healthy 4.2%. Our outlook calls for a -2.7% earnings decline on a weighted average basis, but in a scenario where the economy enters even a mild recession, we think earnings growth could potentially fall even further, up to 10%.

There are also many other things that could upset investor sentiment in coming months. We think a US debt default will ultimately be avoided; however political turmoil in Washington indicates resolving the latest debt ceiling crisis won’t come without some level of market volatility. At the same time, geopolitical concerns have not gone away. Russia’s war with Ukraine continues to rage on, and while the ending of China’s Zero COVID policy has so far gone better than expected, reopening is bound to be a bumpy affair. We remain in a risky environment, and though the US may be insulated to some degree from external shocks, as we’ve been repeatedly reminded over the past two years, what happens halfway around the world can have significant reverberations here at home.

Nevertheless, at some point over the next six to 12 months, we think investment conditions will likely begin to improve. Relative to the eve of prior recessions, US banks remain well capitalized, consumer and corporate balance sheets are healthy and the labor market is strong, all of which should help mitigate against the risk of a short and shallow economic downturn turning into something deeper and longer lasting. We also expect inflation to continue to show signs of sustained moderation, allowing the Fed to eventually pause their tightening campaign when the policy rate reaches around 5%. This won’t be a cure-all, but a Fed moving to the sidelines should allow the economy and markets to find more sustainable footing.

For now, we remain happy with the de-risking steps we’ve made over the past year in client portfolios and continue to maintain our cautious approach to asset allocation positioning. Importantly, we have yet to see that capitulation or “throw in the towel” moment that can typically occurs at the end of bear markets, and our focus on holding high-quality and income-producing US stocks and bonds can help provide client portfolios with relative stability until market turbulence subsides. Still, if we are right about all this, then we are also likely coming closer to the end of this painful reset in asset prices. In the months ahead, bonds may continue to struggle with rising interest rates, but higher rates have already brought a much-improved outlook for fixed income investors, who have not seen yields at these levels in many areas of the market in more than a decade. Likewise, though stocks may face additional downside pressures as earnings expectations are revised down, significant repricing has already occurred.

While it can be difficult, this is a good reminder for investors that it is important to focus not on where returns have been, but on where they could go in the quarters and years ahead. There is likely more volatility to come, and it’s not certain that we have seen the lows for this cycle, but we think it is increasingly probable that conditions will unfold for a more durable recovery into the second half of the year. However, a meaningful lowering of inflation and some earnings growth visibility will first likely be necessary before risk assets find their bottom. Until then, we remain patiently vigilant, watching for conditions and signals to improve.


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