• Like every asset class 2022 was challenging for fixed income on back of rising inflation
  • As inflation falls, economy slows, and interest rates fall then bonds may see better performance
  • As bond yields peak and retrace lower the 60/40 portfolio may become more attractive again

Bonds had fallen out of favour with investors over the past few years as many shifted towards more riskier assets like equities in search for higher yield/return.

But could we see a return of the traditional 60/40 balanced – mixing growth and defensive assets – portfolio in 2023? Franklin Templeton managing director of Fixed Income Australia Chris Siniakov said 2022 was challenging for both equity and fixed income on the back of rising inflation.

“There were challenges coming out of covid with supply chain issues and recomposition of global economies to goods away from services that were driving inflation pressures,” he said.

“But the spike in inflation in the past six to nine months really came from the conflict in Ukraine on top of the existing pressures so almost like the perfect storm in a way for inflation.

“We’ve seen relatively unprecedented pace of central banks’ monetary policy tightening around the world, not just in developed markets but emerging as well.”

Australia’s inflation rate announced last week shot to a 33-year high in the last quarter to 7.8% YoY, or 1.9% QoQ.

The headline figure, which was 7.3% in the previous quarter, came in better than the RBA predicted at 8%, but higher than the economists’ consensus of 7.5%.


Inverse relationship between bonds and equities

Siniakov said while bonds have historically been a good diversifier for a portfolio with an inverse relationship between bonds and equities it doesn’t always hold.

He said for a 60/40 portfolio to work there needs to be a negative correlation between bonds and equities which doesn’t happen in high inflation environments.

“If you look at long term studies and the correlation of between bonds and equities say over the last 125 years it’s positive about 60% of the time,” he said.

“Regimes are important so if we’re in a new inflation regime then 60/40 won’t work.”

Last week’s news of the latest increase in the Aussie inflation rate and its implications for policy rates took 10-year Australian government bond yields sharply higher.

Siniakov said when inflation dominates the investment narrative then the focus turns to what central banks will do to curb inflationary pressures.

“As a result, we’ve seen bond yields reprice higher to reflect the more aggressive policy outlook for central banks globally,” he said.

However, if there are signs inflation is going down and consequently monetary policy is likely to soften then the 60/40 portfolio will again make sense.

“That creates an inflection point for markets and we start to see yields peak and even maybe retrace a little lower,” he said.

“You can see potentially yields and monetary policy from central banks could go back to the 60/40 attributes.”

Siniakov said equities and risk assets don’t normally do well during an economic downturn whether a shallow downturn or recession.

“The prices on that 60% of your portfolio are under pressure and that’s when you want the 40% to work for you,” he said.

“And that is what has typically happened in the last three or four decades in a low inflation regime but where we have inflation the 60/40 portfolio won’t work and that was proven in 2022.”


Economic downturn good for bonds

Siniakov said in a slowing economy as central banks bring down the cash rate it acts as an anchor for yield curves with prices in bond markets rising.

“As the lags in change of policy flow through to the economy which is probably middle of this year the economy will slow down and it’s not a matter of if but by how much,” he said.

“At the same time other asset classes trying to look through uncertainty of a recessionary environment they’re prices may be staying at the depressed levels or going lower, so you start to get the benefit of diversification in a portfolio.”


Bonds back in vogue in 2023

Siniakov said bonds have been out of favour for much of the last decade on the back of central banks’ quantitative easing programs suppressing yields everywhere.

“In some countries the cash rate was zero or negative and 5, 10 year yields were very low so why would you invest in that market if you’re not going to earn anything out of it?” he asked.

“Central banks did that to crowd investors out of defensive assets like cash and bonds and deploy the capital into parts of the economy that would generate innovation and growth.”

He said central banks knew their quantitative easing programs were were having little impact on inflation but what changed through covid-19 was governments also came in with stimulus fiscal policies.

“It was a combination of those two factors that created enormous amounts of cash looking for goods in an otherwise shut down economy, creating that inflation,” he said.

However, Siniakov said signs are positive inflation is easing and January is shaping up to be one of the strongest monthly returns in global markets and 60/40 portfolios seen in the last decade.

“Markets are comfortable central banks have got ahead of the inflation curve and so therefore that aggressive stage of policy tightening can be relaxed and so we should see 60-40 portfolio come back in vogue,” he said.

“But for now, it appears central banks are getting on top of inflation so we can get back to comfort zone of a 60-40 portfolio.

“The reason you hold the 40% in your defensive or bonds is so when the 60% meaning equities are struggling the bonds are going ok and holding up returns of the portfolio.”

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