Why 2022 challenged the traditional 60/40 portfolio approach: Rob Harrison

Usually, equities and bonds maintain balance in a portfolio when the market is both high and low.

If the economy is picking up, then this is positive for company earnings and equities.

At this point in the cycle, interest rates are generally raised to slow the economy down, which is a negative environment for bonds.

Conversely, if the economy is slowing down, then equities tend to fall as company earnings fall and central banks lower interest rates.

This is however positive for bond markets, as when interest rates fall, the value of the bond goes up. If the bond value stayed the same, you would be receiving a higher interest rate than the rest of the market.

So, what happened in 2022 to challenge the 60/40 approach?

Initially, we saw inflation rise sharply which meant central banks had to raise rates to bring inflation under control and slow the economy.

This also had the effect of equity valuations falling, as higher interest rates meant investors were willing to accept a lower valuation for equities.

At the same time, central banks started to apply ‘quantitative tightening’, by selling bonds back into the market, which effectively reduces the amount of money in financial markets.

This followed the last decade, where central banks were buying government and corporate bonds (quantitative easing) to stabilise markets and put money into the system to help economic growth.

Quantitative tightening is the reverse of quantitative easing and has had two effects.

Firstly, there are more sellers of bonds and secondly, the biggest buyer of bonds has now left the market.

As money comes out of the markets, this lowers the prices of all assets.

Inflation also then started to hit company earnings and investors expected that higher rates would dampen the economy, which is also negative for equity.

Essentially, this all created a perfect storm for bonds and equities, with both asset classes falling together.

There were very few places to hide for investors in 2022, with only a handful of alternative investments offering positive returns against a backdrop of bonds and equities both losing ground.

To put this into perspective, this is only the fourth time in a century where equities and bonds have both fallen together and investment approaches should never be judged on ad hoc events.

Time will tell if bonds and equities will move in the same direction again this year, however from the current starting point it is a very different market dynamic than in 2022, with bonds now providing a meaningful positive return.

There are lessons to be learned, with some investors focusing on alternative investments as well as the bond and equity markets, but the main takeaway is not to panic and make rash investment decisions based on a short timeframe within the markets.

Rob Harrison is Head of Research at Progeny Asset Management