The challenges facing the traditional 60/40 portfolio

The second quarter of 2022 saw the worst combined quarterly performance from global equities and bonds in over 30 years – and the worst start to the year for bonds since 1788. Against a backdrop of high inflation and a return to more conventional monetary policy, the correlation of global equities and bonds moved into positive territory. This has significantly reduced the ability of government bonds to diversify portfolios.

No place to hide in traditional asset classes

Past performance is not a guide to future performance and may not be repeated.  

This has not been entirely surprising. We have spoken before of the challenges facing the traditional "60:40" portfolio¹ and the difficulty in delivering meaningful diversification in a world of low but rising yields. Over the past 12 months, we have had a clear preference for alternative assets (including total return funds, gold, real assets and commodities) over fixed income as a way to diversify risk. This helped performance over the second quarter, continuing this year’s trend of strong relative performance from the different components of our alternatives allocation.

YTD performance of alternative assets vs UK gilts (Total return, GBP)

_{Source: Lipper, Cazenove Capital, July 2022.}

Past performance is not a guide to future performance and may not be repeated. 

As we move into the second half of the year we remain positive on alternatives and are happy to maintain an overweight position across multi-asset models. We are however conscious that government bond valuations have meaningfully corrected this year, with the US 10-year yield ending the quarter above its 20-year average at 3.15%. They now look more attractively valued in comparison to recent history.

We continue to believe that nominal government bonds are a good hedge against a recessionary environment. While a global recession is not yet our base case, the probability of recession in the next 12 months has increased and over the medium term we are likely to look for opportunities to gradually add back to government bonds. This would increase the defensiveness of our portfolios.

Global equity markets fell 15.7% over the quarter in USD terms taking YTD performance to -20.2% (-11.0% in sterling terms). Over the quarter, energy and defensive sectors outperformed, whilst growth sectors including technology and consumer discretionary lagged.

Second quarter performance of global equity sectors (total return, USD)

_{Source: Datastream, Cazenove Capital, July 2022.}

Past performance is not a guide to future performance and may not be repeated. 

While sector performance was broadly in keeping with trends we have seen this year, the headline figures mask a shift in the drivers of market returns.

There have been three notable "risk-off" periods this year. Inflation (exacerbated by the invasion of Ukraine) and “hawkish” monetary policy triggered the first two risk-off periods between January and early March and again between April and late May. However, the sell-off towards the end of the quarter was more a reflection of concerns around the prospects for medium-term growth. The elevated cost of living is hurting consumer confidence, reducing demand and raising the risk of recession.

The first two risk-off periods were characterised by rising interest rates and the strong performance of commodities. This combination allowed value and resource equities to significantly outperform, while more interest-rate sensitive equities that were trading at high valuations (e.g. technology) led the market lower.

Three distinct risk-off phases this year 

_{Source: Datastream, Cazenove Capital, July 2022.}

Past performance is not a guide to future performance and may not be repeated. 

More recently, there has been a slight reversal of leadership, with the global energy sector falling 11% since the start of June and growth marginally outperforming value. If we see investors continue to worry more about recession than inflation, we could see a more persistent reversal of the trends we have seen within equity markets so far this year.

Our focus remains on managing risk within multi-asset portfolios and ensuring we hold the right diversifying assets. We are underweight equity compared to our strategic asset allocation and continue to have a preference for large, high quality and more defensive businesses which we feel are better placed to navigate potentially volatile market conditions in the second half of the year.

¹ A portfolio comprised solely of 60% equities and 40% bonds.