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Signs that inflationary pressure may become more entrenched has weighed on consumer and business sentiment © Bloomberg

An important relationship between equities and government bonds broke down during September and inflicted the largest losses for diversified investment portfolios since the pandemic market rout of last year.

Signs that inflationary pressure may become more entrenched have weighed on consumer and business sentiment. That helped prompt the first monthly loss in the S&P 500 since January. Treasury bond yields have risen, as investors anticipate the US central bank may act to tame rising inflation pressure next year.

Losses in the two major asset classes resulted in a typical 60/40 portfolio containing US equities and government bonds falling 3.5 per cent in September. Not since a decline of 5 per cent in March of 2020 has the 60/40 mix suffered such a large loss, according to FT calculations.

The combination of falling equity and bond prices during September “is a problem for all investors and not only asset managers,” Seth Bernstein, president and chief executive of AllianceBernstein told the Financial Times.

For the past four decades, a 60/40 portfolio has provided investors with solid returns and lower levels of volatility. The strategy is a mainstay of retirement portfolios and older savers often shift the balance in favour of bonds for their fixed income.

The appeal of a 60/40 strategy rests with how a majority stake in equities provides exposure to growth through companies expanding their earnings. A smaller slice of high-quality bonds acts as a stabiliser in a portfolio and they have typically risen in value during times of market stress for equities.

Column chart of US 60/40 portfolio, % return from previous month  showing Investors suffer as both equities and bonds fall in value

During the decade from 2010, the 60/40 portfolio provided an annualised return of 10.2 per cent and provided investors with a gain of 15.3 per cent last year.

A period of prices for Treasury bonds and equities both falling together “ultimately depends on whether current inflationary pressures are a transitory or a persistent phenomenon,” said BCA Research.

Bernstein warned investors should prepare for greater market volatility, and faced much lower returns from owning a diversified portfolio of stocks and bonds in the current decade.

“The 10-year yield can easily rise to 2 per cent,” and “investors are entering a period of much greater volatility for bonds given the uncertainty over inflation and the small amount of income they now provide,” said Bernstein.

While the 60/40 mix has gained 8 per cent in 2021, a challenge for investors owning a combination of equities and bonds is that both markets are richly priced, limiting the scope of future gains.

“It is mathematically impossible to repeat the record of the 60/40 portfolio over past decades because rates are now so low,” said David Giroux, portfolio manager at T Rowe Price.

Vanguard last week updated its forecast of expected 60/40 returns for the coming decade and their capital markets model has a median annualised gain of 3.8 per cent through to 2031. The median annualised return over the next decade for the S&P 500 is estimated at 3.2 per cent.

“Our forecasts today tell us that investors shouldn’t expect the next decade to look like the last, and they’ll need to plan strategically to overcome a low-return environment,” wrote Joseph Davis, chief economist at Vanguard.

That has prompted investors to explore owning alternative assets such as real estate and private credit in a balanced portfolio approach.

“I run a portfolio that competes with 60/40 strategies and it does not contain Treasuries and we also think most equities are not attractive,” said Giroux. The T Rowe Capital Appreciation fund owns utilities that pay dividend yields of 3 per cent, alongside leveraged loans and bank debt that are less volatile and should match the return of a riskier all-equity portfolio.

“In five years’ time I would not be surprised to see 4 per cent annual return for equities,” said Giroux.

Bernstein said investors should hold fewer bonds and own more equities in their portfolios. While that approach means tolerating greater portfolio volatility, having some bond exposure will help protection against a big drop in equities.

“Everyone thinks about diversifying, but it comes back to owning fixed income or being in cash,” he said. “Alternative assets and hedge funds don’t provide the scale [of diversification] to protect a portfolio for many investors.”

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