We’ve moved past peak support from the world’s central banks, and tightening monetary policy has profound implications for financial market returns over the next 10 years.
- The investor in the proverbial balanced fund—60% stocks and 40% bonds—has been blessed with robust returns and low levels of realized risk since the global financial crisis.
- However, an unusual set of circumstances produced these favorable results, and our analysis of the diversification and return sources suggests that conventional 60/40 portfolios are unlikely to deliver a comparable outcome for the decade ahead.
- What can investors do? Consider strategies beyond the mainstream, such as absolute return approaches, which may invest in niche asset classes, long/short relative value positions, and other strategies seeking to capture changing foreign exchange or interest-rate differentials.
The particularly strong capital market returns in recent years have reversed the losses of the 2008 global financial crisis. Indeed, the last several years for 60/40 stock-bond portfolios have been especially robust, when viewed in terms of risk-adjusted returns. However, an unusual set of circumstances combined to produce these results. Analysis of the sources of returns suggests significant risks to their future. Over the next 10 years, it appears likely that returns from stocks and bonds will compress, and that historical sources of diversification might fail. We base our analysis on a portfolio of 60% U.S. equities and 40% U.S. government bonds. Investors in such traditional stock-bond portfolios who may be concerned about future return and diversification potential should consider broadening their portfolios to include a wider range of investment opportunities.
Since 2008, the market has generated exceptional results for investors
A classic 60/40 portfolio, represented by 60% S&P 500 Index and 40% 10-year U.S. Treasury notes, delivered a 7.1% annualized return for the decade ended December 31, 2017. In the darkest days of 2008, few investors would have believed such an outcome achievable.1
Meanwhile, the representative 60/40 portfolio’s volatility has been extraordinarily low, a feature reflected in the length of time since a 60/40 portfolio experienced a 10% total return drawdown. The better part of a decade has passed since the last 10% peak-to-trough fall, nearing the record for the longest period—set in the years leading up to the Great Depression—without a 10% drawdown.1
The postfinancial crisis era has delivered mainstream asset class returns well above expectations, but it’s important to examine the combination of factors that led to those favorable returns and assess the likelihood of such a generous return environment continuing.
Monetary policy set the stage for 60/40 funds—it may drop the curtain, too
In the aftermath of the financial crisis, the global economy faced grave economic challenges. Cyclical problems created by the market crash, combined with longer-term structural issues—aging populations and falling productivity—meant that central banks had to step in with extraordinary measures of monetary support. These measures have proven effective in boosting investment returns for risky assets, such as equities. As the economic cycle has progressed, the worrisome threat of runaway inflation, which some argued might result from such high levels of monetary support, never materialized. The environment of solid growth and benign inflation provided ripe financial conditions for 60/40 portfolios to succeed.
However, we doubt that these conditions are likely to persist, given today’s interest-rate environment—which is different in many ways from that of prior periods.
The three main components that determine the level of bond yields—real short-term policy interest rates, inflation expectations, and the term premium—have changed over the past 10 years. Declines in all three of these components have caused the overall yield of the 10-year U.S. Treasury note to fall.
Real short-term policy rates have remained below historical averages
Coming out of the financial crisis, short-term policy rates were lowered as part of the recovery mechanism. For instance, in the United States, weak domestic growth and higher levels of unemployment than in past recessions prompted the U.S. Federal Reserve (Fed) to reduce interest rates to roughly zero, an unprecedented low level, in an effort to kick-start the economy. While the Fed has moved past peak monetary policy accommodation, factors that have created an ultralow real policy interest-rate environment remain prevalent across much of the world today.
Inflation expectations have also stayed subdued
It was not so long ago that central banks in developed countries were fixated on keeping inflation low. Today, long-term inflation expectations have been holding at low levels, suggesting investors believe a structural shift in the inflation-generating process has taken place. This has counteracted the rise in inflation expectations that would normally accompany the flood of macroeconomic liquidity and monetary support we have experienced in recent years.
Bondholders should mind the shrinking term premium
The term premium for bonds—the additional compensation that bond buyers require for the risk of holding a longer-term bond instead of a shorter-term instrument of comparable quality—has also shrunk. We believe the scale and size of global central bank monetary support—notably quantitative easing programs, which began in late 2008—have played significant roles in compressing the term premium.
Central banks stand poised to pare support for asset prices
We’ve moved past peak support from the world’s central banks, and tightening monetary policy has profound implications for financial market returns over the next 10 years. It’s our view that investors will have to consider more carefully how they allocate capital from this point forward.
We see three key positive developments that indicate we are returning to a more robust and self-sustaining global economic cycle—a pickup in growth, in inflation, and in demand.
Global pickup in economic growth
First, economic growth is far healthier and more widely spread across the globe. Recovery in domestic demand has broadened from the United States to Europe and Japan. Although China’s economy is slowing as high debt levels impede its growth potential, China has managed to avoid a so-called hard landing. Since the financial crisis, labor markets around the globe have tightened significantly, credit conditions have eased, and private-sector balance sheets in many cases have been repaired.
Inflation risks are no longer to the downside
With the slack in labor markets diminishing, upward pressure on wage growth is mounting. Moreover, the global economy no longer has to contend with the deflationary forces of the negative commodity price shock experienced in 2015.
Increased domestic demand
Increased domestic demand reassures corporations about future growth, which should in turn help restore capital investment to levels typical of past cycles. Stronger investment would help improve the quality and length of the economic cycle as it moves into more mature stages.
Although these three developments are supportive of higher interest rates in the near term, there are countervailing factors at play over the longer term. Structural challenges, including aging populations that reduce the workforce and slower productivity advances among those workers, are reducing the potential for economic growth. We believe that, in the absence of major reforms or public investment, developed economies will move into a new world of lower growth for the foreseeable future. This will require lower interest rates than we have observed in past economic cycles.
How might 60/40 stock-bond funds fare in this changing environment?
We recently examined the 10-year outlook for 60/40 stock-bond portfolios under three potential future scenarios. Our central expectation—where we see the highest probability—reflects a scenario where inflation rises to central banks’ targeted levels and remains steady. Our upside case incorporates an economic growth and productivity boom, while the downside case of secular stagnation reflects growth that disappoints and inflation that declines.
How might these different outcomes affect 60/40 fund performance prospectively? Badly, we think. Even in the most favorable plausible scenario, we don’t expect balanced mandates to match their long-run average return. With stretched valuation multiples, U.S. stocks are likely to generate a return premium that falls below historical levels. However, the much more significant problem for 60/40 stock-bond portfolios concerns the fixed-income allocation. Recall bond prices and interest rates move inversely. Cyclical forces that should increase inflation, combined with the removal of highly accommodative monetary policy—that is, central banks ceasing their bond purchases—will naturally raise interest rates and therefore depress bond returns in both our central and upside cases. Even in our downside case, with current yields so low, we don’t expect bonds to provide the protection or return potential they once offered investors.
Preparing for tough times requires a little imagination—and simulation
Clearly, investment returns are not the only material factor. Investors seeking returns while trying to manage market risk can’t count on bonds to provide the capital protection they’ve demonstrated over recent decades. Therefore, we can no longer rely on historical correlations to guide us through future stressed market environments.
Standard practice in examining multi-asset portfolio risk is stress-scenario testing, which measures the likely behavior of a portfolio under adverse market conditions. Typically, this modeling is backward-looking, relying on historical events and the past behavior of assets to tell us about portfolio performance potential in the future. This approach is largely objective—since we know what equity and bond markets did in past stress environments— and, if the portfolio works well under historical stress, it suggests a fair degree of durability of the diversification within it.
However, although historical scenario testing provides a set of demanding conditions for testing the resilience of a portfolio, the likely behavior of assets under future market stresses requires a more subjective perspective. This is particularly true today, when we consider the expensive valuations of both equity and bond markets.
Recognizing the need to supplement our historical scenario analysis, we developed a proprietary forward-looking scenario analysis approach. To model potential future events, we first consider extreme—but plausible—future stresses that could significantly impact markets. Drivers include economic, geopolitical, technological, and environmental factors, among others. Stepping beyond the assumptions of traditional stress modeling, we combine the opinions and judgments of experts with quantitatively determined relationships, creating a set of richer and more coherent scenarios. Importantly, it allows us to think about diversification more holistically and evaluate the full investment toolkit available to us to better protect our portfolios.
We put forward our broader medium-term expectations for 60/40 returns, highlighting that bonds don’t represent the source of protection to portfolios they once did. Furthermore, we identify a number of stress environments where bond returns could be particularly painful. For instance, environments where key central banks are forced to increase interest rates faster than expected, or stagflation environments with slow growth and rising inflation. In this world of low interest rates, alternative sources of portfolio diversification will be more essential than ever.
When we study a range of stressed-market tests against our diversified multi-asset portfolio of 25 to 35 longer-term investments, we find the portfolio holds up better than the global equity market in each case. These scenarios include historical events. We also examined forward-looking scenarios, including those representing China in crisis and a regime of stagflation. In such stressed market conditions, our scenario testing indicates that the portfolio would lose money, but it would likely suffer only a fraction of the losses that equities would be likely to accrue.
What to do now—look beyond mainstream markets
We believe the key to delivering both return and diversification potential within multi-asset portfolios is to broaden investment flexibility. We suggest that investors consider different, nontraditional ways of generating absolute returns while still diversifying their portfolios.
A portfolio of 25 to 35 carefully selected longer-term diverse investments can replace—or, at the very least, complement—conventional stock-bond portfolios because it can seek to exploit return opportunities across a broad range of asset classes and geographies. This wide-reaching multi-asset portfolio should seek to cover a diverse array of economic and secular themes in global financial markets, with the goal of delivering stable returns in a variety of market conditions.
With far greater investment freedom, multi-asset portfolios can cast the net wider in the search for investment ideas, including:
- Emerging-market debt or high-yield corporate bonds, or listed exposures to equity sectors such as real estate and infrastructure
- Relative-value positions that provide potential for positive returns even in falling markets—a long/short pairing of U.S. large-cap versus small-cap equities, for example
- Carry positions that seek to capture an interest-rate differential, for example, between shorter-dated and longer-dated bonds, or between the bond market of one country and another
- Foreign exchange positions to express a view on the relative exchange rate between two countries’ currencies
These are just a handful of the many ways to generate returns outside of traditional, major market long-only exposures. We believe strategies like these will become increasingly important as equity returns fall to levels aligned with historical norms, and with fixed income unlikely to deliver meaningful returns under any of our forecast scenarios.
Multi-asset absolute return portfolios offer potential solutions for investors seeking returns in a risk-conscious way. As with any investment, there are no guarantees, but we have carefully constructed our strategies to seek returns under a wide range of future market challenges. We believe they’ll deal well with whatever circumstances the next downturn brings.
1 Standard Life Investments, 2018.