If you’ve read anything about financial markets over the last few years, you have likely seen something about the struggles of the bond market and the “death of the 60/40 portfolio.” Undoubtedly, that’s a catchy headline that will garner a lot of clicks, but is there any legitimacy to the underlying story? Let’s take some time to dig in.
It takes little time to see where dire headlines come from, as it has been a historically tough few years in the fixed-income markets. As of the end of October, the three-year total return of the Bloomberg U.S. Aggregate Bond Index was down -16%, the largest in history. Similarly, the same index was amid 39 straight months of drawdowns, about 2.5x longer than the previous longest drawdown. Those two statistics alone are enough to start making the argument against bonds and the 60/40 portfolio.
In addition to the poor performance, there has been a compounding factor related to the correlation to equities. Generally speaking, fixed income and equities have had a low correlation throughout history. This has manifested historically in periods with poor equity performance as a “flight to safety,” which meant increased demand for bonds, rising prices, and giving a buffer to equity declines. However, over the last few years during the rate hiking cycle, bond prices have been declining, which in 2022 coincided with equity declines. This clearly illustrates dramatically increasing correlations, which limited the diversification benefit of bonds. In fact, the correlation over the last two years is the highest it has been since the early 1990s.
Given the challenging backdrop over the last few years, the past two months have been a welcome reprieve. Moreover, last week, the unexpected dovish pivot from the Fed provided even more fuel for the bond rally. The Bloomberg U.S. Aggregate Bond Index is now up almost 9% from its October closing low, a staggering move. The move is the most significant short-term increase ever (rolling 40-day period), with data going back to 1996. This comes as the 5-year Treasury note has declined from a high of 5% in October to 3.9% currently.
While this rapid change in fortune in the bond market does not mean the rally will continue, there is still reason to be optimistic. And that is because rates remain elevated relative to the last 15 years. And what is the single best predictor of fixed-income returns? As you may be able to guess based on the preceding, it’s initial starting rates. And with rates still at a good place, forward-looking return expectations are near their highest point in nearly 15 years.
So, is the 60/40 portfolio dead, and should you steer clear of fixed income forever? The answer is pretty succinct: no.
And finally, Merry Christmas to all who are celebrating on Monday. We hope you have a wonderful time.
Economy
- Markets have continued their steady upward march since October lows, with the S&P 500 up 0.8%, the Nasdaq up 1.2%, and the small-cap Russell 2000 up 2.5%.
- Core PCE prices in the U.S. increased 0.1% from the previous month, below market estimates of 0.2%, and holding unchanged from the downwardly revised increase in October.
- Preliminary data showed that building permits in the U.S. fell by 2.5% to a seasonally adjusted annual rate of 1.46 million in November, below market expectations of 1.47 million.
- The average contract interest rate for 30-year fixed-rate mortgages with conforming loan balances fell by 24bps to 6.83% in the week ended December 15, 2023. It was the lowest level since the week ended June 23, 2023.
Stocks
- U.S. equities were in positive territory. Communication Services and Energy were the top performers, while Utilities and Consumer Discretionary lagged. Growth stocks led value stocks, and small caps beat large caps.
- International equities closed higher for the week. Developed markets fared better than emerging markets.
Bonds
- The 10-year Treasury bond yield decreased three basis points to 3.90% during the week.
- Global bond markets were in positive territory this week.
- High-yield bonds led for the week, followed by government bonds and corporate bonds.
