The negative correlation between bonds and stocks is no longer a certainty due to structurally higher inflation expected in the coming decade. It has therefore become an “absolute necessity” to complement the traditional 60/40 portfolio with alternatives, said Vincent Juvyns, global market strategist at JP Morgan Asset Management, during the firm’s presentation of its outlook for the second half of the year.
Juvyns began the outlook by acknowledging the mismatch between the economic macro picture and the asset allocation in the 2023 outlook, which JP Morgan AM provided six months earlier. “We were too conservative. Due to various external market conditions, it was challenging to translate the economic macro picture into asset allocation. Our preference for bonds over stocks has cost us returns. We did not anticipate the strong rally.”
The classic investment portfolio, filled with 60 percent stocks and 40 percent fixed-income securities, suffered significant losses last year. However, from May of this year, that portfolio has shown a positive return of approximately 7 percent. The positive correlation between stocks and bonds, which has persisted since last year, has nevertheless “awakened” investors, according to Juvyns, addressing investors in Amsterdam on Tuesday. “The simultaneous decline in stocks and bonds last happened in 1969 and has perhaps occurred only three times in history.”
‘Unreliable negative correlation’
Over the next ten to fifteen years, inflation is expected to be between 2 and 3 percent, surpassing the targets of the ECB and the Fed, Juvyns said. This makes the negative correlation between stocks and bonds, the shock absorber of the classic 60/40 investment portfolio, less reliable. “Decorrelation remains important. From a diversification standpoint, alternative investments have become an absolute necessity in traditional asset allocation.”
JP Morgan AM calculated the average annual returns and volatility, with varying proportions, between 1989 and the third quarter of 2022 for an investment portfolio consisting of stocks, bonds, and alternatives. The alternative investments included private equity, real estate, and hedge funds in equal percentages. The allocation of 50 percent stocks, 30 percent alternatives, and 20 percent bonds showed the highest return, while the allocation of 30 percent stocks, 40 percent bonds, and 30 percent alternatives resulted in the lowest volatility.
Other investment banks now also regard alternative investments as an essential component of institutional investment portfolios. Presenting its midyear investment outlook, Luxembourg-based Quintet Private Bank advised clients to add for example liquid hedge funds to their portfolios.
US Treasury bonds
When considering the classic components of the 60/40 portfolio, Juvyns is most positive about US Treasury bonds because “they provide income now that interest rates have risen. The real returns are the most attractive in fifteen years.” The market strategist finds spreads of investment-grade bonds more interesting in Europe than in the United States. For high yield, the increasing risk of default is not compensated by the current spreads. “High yield is sensitive to the tightening of credit markets. We want to protect ourselves against the rising default rate.”
With a quarter of slowed economic growth ahead, Juvyns takes a neutral stance on stocks. “We want to be defensively positioned in quality stocks of large companies, rather than in small caps, which are more dependent on bank lending.”