The 60/40 formula for buy-and-hold investment portfolios may return between 4% and 5% and become less risky next year, as major central banks gradually pivot from ratcheting up interest rates to lowering them, according to Goldman Sachs Research. This follows two years of relatively poor performance.
Returns for the 60/40 portfolio — traditionally split between the S&P 500 Index of stocks (60%) and 10-year U.S. Treasury bonds (40%) — will probably be limited. That’s because the stock market is already priced for a soft landing, and markets are already pricing many rate cuts. But at the same time, inflation is cooling and bond yields are still higher than they were a year ago, especially in real (inflation adjusted) terms, offering more of a cushion and a buffer against shocks, says Christian Mueller-Glissmann, who heads asset allocation research within portfolio strategy in Goldman Sachs Research.
“The best way to put it is there is less downside risk, but also very little upside risk,” Mueller-Glissmann says of the 60/40, or balanced, portfolio. “It's not a hitting-it-out-of-the-ballpark performance.”
We spoke with Mueller-Glissmann about his team’s outlook for 2024, the role for commodities and real asset investments in a balanced portfolio, and the potential benefits in the year ahead from investing in private markets.
Cash is yielding around 5% in the US, but your team recently changed your investment allocation from overweight cash to neutral. What’s behind your view on being fully invested?
We've been overweight cash for the majority of the last two years, as we did not expect a strong risk-reward from 60/40 portfolios. And this was because, on the one hand, cash was getting more attractive because you had central banks raising rates. But I think you also had the other asset classes at elevated valuation levels that were constraining upside and increasing downside risk. At the end of 2021, both equity and bond valuations were near their 150-year highs, and that just created a very poor entry point for being invested.
So valuations for the traditional asset classes — equities, bonds, and to some extent credit — were less attractive. And this has flipped around quite a bit in the last two years with a major sell-off in 60/40 portfolios. You've seen a major decline in fixed income valuations and an increase in yields.
Central banks have raised rates materially, and that pushed up bond yields. If you look now at the US 10-year yield, it has actually risen close to its 300-year average.
We are back to something more normal after 20 years of bond yields being depressed by low inflation and central banks fighting deflation to some extent. So the bond market is in a much better spot with regards to valuations.
Equity risk premia on the flipside are very low. So if you consider high bond yields, equity valuations seem actually, relative to bonds, elevated. But if you take out the magnificent seven from the S&P 500, or if you look at Europe, or Asia, you actually find that equity valuations in absolute terms are more in line with the average since the 1990s.
Equity valuations are still a bit elevated compared to the last 100 years. But broad equity indices right now are not comparable to the last 100 years. The largest companies are often more profitable, higher quality, and in some cases offer different growth optionalities as well with the technology revolutions that are going on.
Importantly, cash is also getting less attractive over the next one to two years, because we expect central banks to cut. So that's the argument of shifting back to being invested, going back to buying traditional asset classes, and maybe also going back to the 60/40 portfolio, which is something we've been quite worried about over the last two years.
What underpinned your team’s shift to neutral on fixed income from underweight?
The valuation starting point is better now. Bond yields are higher, and that's both true for sovereign bonds and it's true for fixed income broadly, like corporate credit. With higher yields, the return from carry has also improved, making being underweight fixed income relatively more costly. The summer sell off in bonds did create a particularly attractive entry point for longer duration bonds. Since then, unfortunately, bond yields have come down quite a bit again. But we would take any increase in bond yields in the next few months as an opportunity to increase fixed income allocations.
We also do expect central banks globally to be at the end of their hiking cycles — the Federal Reserve, the Bank of England, and the European Central Bank. And that removes one of the major drivers of downside risk for bonds.
And of course we expect inflation to decline further in the US and Europe. The two are linked. We expect central banks to not hike rates anymore, on the one hand, because they reached sufficiently restrictive territory. But, on the other hand, there's been already enormous progress on inflation normalization.
To some extent that was the big surprise to investors this year, where most people thought you need a recession to get down inflation materially. But our economists have been leaning against that. We actually managed to get material inflation normalization without significant growth damage. And they expect more of that next year. That should then not just mean that central banks are actually not hiking anymore, but it opens the possibility of rate cuts.
And suddenly, the bond market has two roles. First of all, it offers you a better yield again, but it might also become a buffer again for equities, or broadly for risky assets in the portfolio, in case of negative growth shocks.
What is your outlook for 60/40 portfolios as we go into 2024?
The best way to put it is less downside risk, but also very little upside risk. Our machine learning model perfectly summarizes how I think about 60/40. The dark blue line is the probability of a large drawdown for the 60/40 portfolio. That probability has come down significantly and is below average, because the inflation momentum remains negative. Inflation is the biggest risk to a 60/40 portfolio because it can trigger central bank tightening which pushes up real rates, which weighs both on equities and bonds.
That risk is now going the other way, where rates can come down and equities can be buffered by bonds. So the downside risk is starting to be lower.
But you can see the upside risk is actually, according to our model, at a low level too. While downside risk is a lot about how much bonds can buffer equity, upside risk is a lot about how much equities can rally. Now this upside risk is capped by the fact that people already reflect a bit of a soft landing in broad equity valuations. But because you avoided a US recession so far, you are also still somewhat late cycle in the US economy, which constrains earnings growth. All in all, we don't expect strong returns for equities for the next 12 months.
But the good news is you are facing lower risk at the portfolio level, which still points to a better risk-reward, and that makes you want to be invested.
Do you think 60/40 will outperform cash, which is yielding around 5%?
I think that’s more likely than in the last two years, but after the strong November rally it is going to be close. It's not a hitting-it-out-of-the-ballpark outperformance.
Possibly a bit higher, depending on where you invest in equities and bonds. But the important thing is less downside risk.
We've talked about stocks, we've talked about bonds. What's your take on commodities for next year?
Commodities have a very useful role in multi-asset portfolios. We found in our research that in periods of high and rising inflation, commodities will be very useful diversifiers for 60/40 portfolios, and we've been recommending an overweight in commodities in our asset allocation in 2022. But now we are in an environment of falling inflation, and inflation is already starting to be, as I mentioned, much closer to the central bank targets.
So the necessity to have commodities as an overweight has come down — we have been neutral since the summer. You have to consider that commodities are a volatile asset class. They are often more volatile than equities, and that means the hurdle rate to allocate to commodities is a bit higher for most asset allocators.
That said, as our commodities team would note, you have to consider geopolitical risk. If you are seeing an escalation of geopolitical risk in the Middle East, there has historically been a link between oil prices and concerns about oil supply and Middle East tensions. So that makes commodities useful as a diversifier.
And then there are long run drivers, which are less about next year alone, such as the long run demand for electrification metals like copper. That's an area where our commodities team is quite bullish for next year because of supply deficits emerging. So, putting it all together, it's a solid neutral.
Anything else from your outlook for 2024 that readers should be mindful of here?
We’ve done a lot work on alternatives. The big upside of a soft landing is that we didn't get a recession. That also is a downside, because the recession usually creates a valuation reset and an economic reset — that creates opportunities for better subsequent returns for traditional assets.
Across assets, opportunities are a bit more limited, which means there's more focus on alternatives, on alpha (i.e. returns that are less correlated with traditional assets) rather than beta. Private markets, private equity, private credit, and venture capital are, in my opinion, highly active forms of asset management — concentrated portfolios with direct engagement with your investments. It becomes an environment for more active investing, for private markets, but also for other alternative investments like hedge funds.
Also I would mention that after the material November rally we have been looking more at hedging strategies for equities and credit as implied volatility has reset materially. While we think the outlook for 60/40 portfolios is likely to be better in 2024, and risks will come down, the market has pulled a large part of the upside forward, and there can be setbacks in the near-term, especially if the macro backdrop disappoints relative to an optimistic baseline.
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