That has been rewarding for passive investors to date—but when trends reverse, a concentration in yesterday’s winners can become a concentration in tomorrow’s losers.
Looking across asset classes, the secret ingredient in the 60/40 portfolio has been the negative correlation between stocks and bonds—meaning when stock prices go down, bond prices go up, providing a nice counterbalance.
Over the last 20 years, the correlation between stocks and bonds have been reliably negative, leading to a much smoother ride for passive 60/40 investors, if one asset class falls, the other rises.
But if we take a longer view of history, and look back over the last 120 years, we see that the correlation between stocks and bonds is usually positive, not negative. In other words, when stocks go down, bonds go down a bit too.
Where investors would really feel this is in the crash periods. If we look back at all the market crashes over the last 20 years, we see that in most of them, bonds delivered a positive return, dulling the pain for 60/40 investors. What worries us today is that bond yields during all of those crashes were a lot higher when the crash started.
Yields had more of a cushion - they were able to fall. Today the JPM Global Government Bond Index, which is exposed only to developed market government bonds, offers a yield of just 0.6 per cent.
That is a problem, because for bond prices to go up, bond yields must be able to go down. And this year, we have seen signs that bond yields may be at their lower limit.
Of course, the headline on bonds this year is that yields fell, and so prices rose, and that is true. They fell where they had room to fall.
Bond yields fell in the US and in the UK, because they had room to fall in the US and the UK, performing as investors with the outcome they expected in a market downturn.
But if we look at bonds in countries like Japan, Germany, France, and Switzerland, where yields were already at or below zero, we see that yields today are higher than they were at points in 2019.
Yields going higher should be a function of revised inflation and growth expectations, factors which have not been present in those countries this year to any greater extent than they have in the UK or US.
That tells us that we may have found the lower bound—the point at which bond yields struggle to go lower. And if bond yields can not go down, then bond prices can not go up, and if bond prices can not go up, bonds will not be able to counterbalance stocks as they have recently.