Traditional 60/40’s Diagnosis – “It’s Reasonably Dead.” PART I

FIVE THINGS YOU SHOULD KNOW

1. Equity Markets – were up this week with U.S. stocks (S&P 500) gaining 0.42% while international stocks (EAFE) rose 0.52%
   
   
2. Fixed Income Markets – were also up this week with investment grade bonds (AGG) up 0.48% while high yield bonds (JNK) gained 0.46%
   
   
3. Global Tax Rates Looking Likely – this past weekend the Group of Seven nations (G-7) reached an agreement to move forward with the U.S.’s plan of a minimum of 15% corporate tax rates on foreign earnings. While details still need to be agreed upon and countries need to sign on, this marks a major step towards enacting a historical global tax plan, with Secretary Yellen calling it a “revival of multilateralism.”
   
   
4. U.S. Looks to Compete with China – this week the Senate passed an expansive bill that will invest almost $250 billion into U.S. manufacturing and technology in hopes of competing with China’s growing economy. This marks one of the first bipartisan agreements in congress under President Biden, with both sides of the aisle committed to meeting the challenges posed by China.
   
   
5. Key Insight – [VIDEO & ARTICLE] As we bring on new clients, and even chat with some advisors, we continue to see lazy portfolio construction based on what’s been, not what will be. Inflation is here for a while, as are insufficient traditional bond yields, which means many retirees are going to get hurt if they don’t adapt their plans.
   
   

The team at TEN is so happy to have Shelby back with us after her maternity leave, we are excited to welcome her beautiful baby girl Emerson, born March 4, 2021, at 6:10pm weighing 6lbs 13oz!

INSIGHTS for INVESTORS

The Problem

We’ve been on record for some time now that the traditional 60/40 is in dire trouble (and no, a few token positions in other assets classes won’t save you). And trust me I’ve heard all the counterarguments, but to me they hold no water at all, and invariably amount to nothing more than quoting past performance to justify stale allocations that are somewhere between lazy and cowardly.

The reality is things have changed, even as portfolios haven’t, consider the foundation of the 60/40 which was based on four key foundational pieces that are no longer present:

1. Deflation or declining inflation – after inflation peaked in the modern era in the 70’s investors, particularly bond investors, benefited from inflation declining and along with it rates which pushed bond values up.
   
   
2. Elevated Bond Yields – traditional bond investors benefited not only from interest rates that were in the high single digits to double digits 40 years ago, but also from their decline which pushed bond values up. With current rates now down between 1-2% those benefits are gone. Sure, they could rise and benefit future bond investors, see last point of the article below by Mr. Desai, but that will do nothing for retired investors who are already all invested and have to experience the losses first.
   
   
3. A Predictable Fed – for years the Federal Reserve had two key mandates which they stuck to, low employment and low and stable inflation. However, post Great Financial Crisis they have become far more aggressive and activist and have also seemed to add a third mandate around social equality as they speak to fair and higher wages with greater frequency. This mindset is likely to lead (and has) to policy that will be far more inflationary, which should hurt bond values.
   
   
4. Growth – after the resurgence after the shutdown and new plans for higher taxes, growth is likely to slow moving forward. This could increase volatility across asset classes, and if coupled with inflation and higher rates (see above) investors with traditional portfolios could see losses across they portfolio.

In short, your old methodology won’t get you there because bonds are arguably not the defensive, uncorrelated asset class they once were and no longer even pay you a yield that can keep up with inflation. Stocks and bonds were both pushed higher on declining rates and liquidity which are likely to abate and now become headwinds for both with greater frequency.

Therefore, not only will your emotions be challenged as you see losses across your portfolio but that reality will also greatly increase the risk to the longevity of your portfolio as your Sequence of Return (https://www.investopedia.com/terms/s/sequence-risk.asp) risk grows and you have to sell assets to pay bills.

The Simple Math of It

Consider the simple math of it.

The 20-year annual average return for the S&P 500 is 6%, which if it comprises 60% of your portfolio gives you a 3.6% return. Current traditional bond yields are around 1.5%, which if 40% of your portfolio gives you a 0.6% return.

So, the likely case is your average total return is around 4%. If you are taking the typical 4-5% distribution your “head is barely above water” and that’s before any volatility, inflation, and/or taxes which will really stack up over a 20 to 30 year retirement and only compound the problem.

At best your plan would likely suffer severe drawdowns as you age and become more risk averse (a bad combination), and at worst your financial plan may be completed busted.

In Summary

With over 25 years since I began in the industry and seeing what really works for people’s peace of mind, along with extensive modeling of the challenges above, my conviction in making sure investors address this issue couldn’t be higher. That is why we continue to pound the table about this topic and why we created our High Income Strategies to solve for it for our soon-to-be or already retired clients.

If you are already a client of TEN in one of these strategies then you’ve tackled these issues already, but I can tell you after seeing the referrals and new clients that continue to come in, that many of those that you know and care about have not.

My goal, whether people work with us or not, is to honor their hard work and sacrifice and play some role in helping them enjoy their retirements – it’s one of the reasons we put the effort and time into these commentaries and give them away for free.

As to the risk from stale 60/40 allocations that still predominate the industry, you don’t have to just take my word for it, below is a great article with comments from various Chief Investment Officers managing over $5 trillion dollars that are raising the very same concerns.

Have a wonderful weekend,

Tim and the team at TEN Capital

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‘It’s reasonably dead’: $5tn CIOs give a grim diagnosis for the 60/40 portfolio

With yields already low, inflation on the rise and equities expensive, the outlook for the traditional balanced portfolio isn’t looking great, according to these CIOs.

Alex Steger by Alex Steger May 2021

The 60/40 portfolio is not quite dead, but its condition appears to be critical.

This was the verdict of five investment chiefs from leading asset managers who took part in Citywire’s CIO Summit.

The Summit brought together CIOs from Amundi, Franklin Templeton, JP Morgan Asset Management, Legal & General Investment Management (LGIM) and T Rowe Price, who between them oversee almost $5tn (R70tn) in assets.

Their pessimistic prognosis for the classic balanced portfolio was based on a dire outlook for bond yields, already pushed low by loose monetary policy and now under pressure from inflation.

And with inflation only expected to rise in the US due to ambitious fiscal programs, increased consumer spending and supply bottlenecks, this will eat further into real yields, raising more questions over the role of bonds in the classic balanced portfolio.

Sonal Desai, CIO of Franklin Templeton Fixed Income, said that it was premature to say 60/40 was dead, but that it was not ideal positioning for the current environment.

Desai said she did not envisage 1970s-style inflation, which ran at an average of 7.1% over the decade, but predicted that price increases would not return to the US Federal Reserve’s target of 2% either and were more likely to be in the range of 3% or higher, which would still leave Treasury investors short.

If the 60/40 portfolio was taking a nap for Desai, it was ‘reasonably dead’ as far as Amundi CIO Pascal Blanqué was concerned, due to bonds failing to be the ‘great diversifier’ they have been historically.

He said the role of bonds in portfolios would need to be reconsidered and that, while bonds could still provide liquidity, additional income would need to be found from other asset classes.

Diversify for income

Blanqué said the fixed income portion of the 60/40 portfolio should be divided in two, with one portion for liquidity and the other forming part of a wider income bucket, which would also include other asset classes and a greater variety of bonds, including securitized debt, emerging market debt and municipal bonds.

‘This is going with the more positive correlation between equities and bonds. It’s on the agenda and it will come,’ he said.

‘So we’ve got the problem of finding diversifiers, new diversifiers, because the great diversifier of bonds versus equities is not dead, actually, but is reasonably dead.’

Sonja Laud, CIO at LGIM, agreed with Blanqué that investors would need to find alternative asset classes to deliver some of the traditional characteristics of bonds in a 60/40 portfolio, namely income, diversification and downside protection.

David Giroux, who runs the $49.1bn T. Rowe Price Capital Appreciation fund, a multi-asset strategy that sits in the Morningstar Allocation 50% to 70% Equity category, said he rarely had 40% exposure to traditional bonds.

Giroux, who is head of investment strategy and CIO for US equity and multi-asset at T. Rowe Price, said other asset classes, such as leveraged loans, and covered calls, could offer better risk-adjusted returns than traditional bonds.

‘We’ve gone from less than 1% of my portfolio a couple of years ago in leveraged loans to more than 10% today. Leveraged loans may be the most attractive part of the market today, on a risk-adjusted basis,’ he said.

‘We’ve gone from 1% back when everybody thought rates were going to go 3% to 4% and we were buying Treasurys at that time, to today, where we’re zero Treasurys and 10% leveraged loans.’

Stock response

While low bond yields are the primary threat to the efficacy of the 60/40 portfolio, global head of equities at JP Morgan Asset Management, Paul Quinsee, highlighted that the yield on equities was also low due to their high valuations.

He noted how the 60/40 portfolio had traditionally returned 6% per annum over the last 30 years, but that this would not be the case in the future. Credit Suisse has projected it may return as little 2% per annum.

Desai pointed out that a new economic cycle could result in yields going up at some stage, meaning that such dire projections may be too hasty.

‘[If yields] start becoming more attractive again… maybe 60/40 wakes up. It’s probably not dead. That might be premature.’ [TEN Cap editor’s note: Desai’s last point here very well may have some merit for investors allocating their investments in the future when rates are higher, but does not have much merit or applicability for investors already within a classic 60/40 mix as they are already in at these lower bond rates.]