The 60/40 portfolio: What’s old is new again

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Rest assured, for now. If U.S. Federal Reserve Chair Jerome Powell were a poet, he might defend the Fed’s historic rate hikes to anxious markets by echoing Robert Frost: “But I have promises to keep, and miles to go before I sleep.” Last week’s Fed meeting confirmed that enough miles have been traveled to warrant a rest — even if it’s a quick catnap instead of a deep night’s sleep. Indeed, despite last week’s pause, the Fed’s new dot plot implies two more rate increases before year end.

Inflation is cooling overall, but there’s still some heat at the core. Headline U.S. CPI showed signs of continued easing last week, increasing just +0.1% from April to May. It rose +4.0% year-over year in May, providing further evidence of a strengthening disinflation trend. Meanwhile, core CPI (excluding volatile food and energy costs) was higher than headline CPI in May, at +0.4% for the third month in a row and +5.3% compared to May 2022. Wholesale inflation has also decelerated, with the Producer Price Index falling -0.3% for the month, coming in below its pre-pandemic average. PPI has been cut in half relative to a year ago, to +1.1% in May from 2.3% in April.

When will inflation fall enough to justify rate cuts? Structural shifts are likely to keep the inflation rate above the Fed’s 2% target in the near- to medium-term. That means more miles to go before monetary policy pivots from pausing to reversing course. But investors can take heart: Year-over-year comparisons (aka the “base effects”) should put additional downward pressure on prices, and June inflation data due next month could be an important turning point (Figure 1). In particular, the rate of price increases in “sticky” components of inflation like shelter may be poised to slow substantially over the next 12 months. And used car deflation — that is, falling prices, not just slower increases — will likely start in June. All of this could affect the way investors might approach portfolio construction.

Portfolio considerations

The ongoing viability of the traditional 60/40 stock/bond portfolio has been debated before, but in 2022 the venerable allocation suffered its worst year since the global financial crisis amid an equity bear market and sharply higher interest rates. With economic and market conditions in flux, we don’t expect a repeat of that poor performance in 2023. But 60/40 investors burned by last year’s too-hot inflation and too-high rates may now be coming to the same conclusion we reached long before the Fed’s aggressive tightening cycle began: Incorporating alternative investments and allocating across credit sectors may offer better downside protection, produce higher yields and create more diversified sources of risk than the typical 60/40 portfolio of yore.

While each individual and institutional investor has unique investment goals and risk tolerances, some common themes may be worth exploring. The higher-for-longer inflation phenomenon could exert a significant drag on traditional stock and bond markets. In our view, this supports the argument for including assets like global infrastructure and private real estate in a diversified portfolio, as both asset classes have historically provided a buffer against inflation. Likewise, allocating to private credit and private equity could potentially enhance a portfolio’s overall risk/ return profile, given their relatively high historical yields and returns and relatively low correlations to public equities and fixed income.

To jumpstart discussions about allocating beyond a traditional 60/40 approach, we propose a hypothetical 50/30/20 portfolio (Figure 2) that invests 50% in equities, 30% in fixed income and 20% in alternatives to capitalize on their differentiated asset class advantages. Incorporating additional asset classes comes with additional asset class-specific risks (such as liquidity risk for many private investments), but we believe gaining exposure to more sources of risk and more potential sources of return would benefit most investors.