60/40: Down, But Not Out

As a general rule, high-quality fixed income investments tend to do well when stocks take a big tumble. Interest rates usually fall when equities are weak, and this provides a lift to bond prices.

Alas, it’s only a general rule. And with all general rules in life, there are exceptions.

This year is a case study in how stocks and bonds can sometimes head south together. Rather than playing an offsetting role for a portfolio, fixed income loses ground, too. 

What Has Happened is Historically Rare

It’s difficult to understate just how rare the combined underperformance of equities and fixed income truly is. As Bespoke Investment Group, a provider of investment insights and data recently wrote:

This has been the 2nd worst period for traditional “60/40” portfolios (60% stocks, 40% bonds) since the 1970s. Only the worst stretches of the Financial Crisis were worse.

Source: Bespoke Investment Group via Twitter

Explaining the Underperformance

Why have stocks and bonds fallen so much (and together)? In a nutshell, rising interest rates. Central banks (the Federal Reserve, the Bank of Canada, etc.) have turned very hawkish in a bid to quell the inflationary pressures that have emerged in the economy. These pressures are the result of soaring commodity prices, tight labour markets, and persistent supply chain issues stemming from the pandemic. 

Raising rates is bearish for bond prices, as the two move inversely to one another. As rates go up, bonds fall. This is especially true for longer-term bonds, as we discussed in a previous post on duration. Simply put, an interest rate increase of 1% will hurt a 10-year bond far more than one of a much shorter maturity.

But rising interest rates haven’t just been bad for bond markets. They’ve also spooked equities. Among other factors, investors are worried that central bank rate hikes will end up tipping economies into recession as a side effect of fighting inflation. That’s sent growth stocks, in particular, tumbling. 

This Too Shall Pass

As painful as this stretch has been for investors, it’s reasonable to believe there’s light at the end of the tunnel:

Stay the Course

The worst time to abandon your long-term investment plan is when markets are a sea of red. It may be tempting to think that a diversified portfolio of stocks and bonds will no longer cut it, but history says you should stay the course. Better times will come. Why? They always have.