From the Archive: The End of Ultra-Low Yields and the Standard 60/40 Portfolio

Part II of Volume I, Issue II

A bedrock of long-term investing, a portfolio split 60/40 between equities and high-quality bonds, posted its worst monthly slide since the market meltdown in the early days of the pandemic. Both equities and bond prices dropped sharply in January as markets priced in a faster pace of interest-rate tightening during 2022 from the Federal Reserve. The central bank’s hawkish pivot from mid-December intensified after last week’s policy meeting, with leading Wall Street economists calling for at least five and possibly as many as seven quarter-point rate hikes this year.

The Bloomberg 60/40 index lost 4.2% in January, reflecting a decline of 5.6% for large cap equities and a loss of 2.2% for the Bloomberg U.S. Aggregate bond index. That’s the worst showing since a slump of 7.7% in March 2020, when pandemic lockdowns plunged the economy into recession.

 - Bloomberg, January 31, 2022

For equity markets, rising inflation was already a big concern. Russia’s attack on Ukraine means those worries just got a whole lot bigger. Vladimir Putin’s move to invade his neighbor led to a surge in the price of everything from oil and food to natural gas and aluminum, spikes that could choke economic activity and exacerbate a market rout.  

Stocks across the world tumbled on the news, with major benchmarks in both Europe and the U.S. now firmly in correction territory and the Nasdaq 100 index entering a bear market.  “The effects of recent events can therefore rightly be described as stagflationary -- rising prices with declining economic activity,” said Thomas Boeckelmann, drawing parallels with the malaise that hit equity markets in the 1970s.

 - Bloomberg, February 24, 2022

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Editor’s Note: This is a reprint of Part II of Volume I, Issue II of The Macro Value Monitor, which was originally published in February 2022. Part I, The Moment When Monetary Policy Runs Aground on the Third Great Mistake, can be found here. A PDF version of the Macro Value Monitor is also available.

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This month marks the anniversary of one of the most significant events of the past decade for investors in U.S. stocks and bonds. When the Covid-19 pandemic began to drag down the financial markets beginning in late February 2020, an unprecedented seismic shift struck the bond market.

In the decade following financial crisis in 2008 and 2009, long-term Treasury bond yields settled into a trading range between 1.5% and 3.5%. This trading range persisted through the beginning and end of successive quantitative easing programs, and also through eight years of near-zero percent short-term interest rates. It also persisted through the Fed’s campaign to increase interest rates and shrink its balance sheet in 2017, 2018 and 2019. It was one of the most durable trends in the post-financial-crisis market landscape.

Yet among the many formerly stable market relationships that changed when the impact of the pandemic hit the economy and financial markets, the most significant for investors was the transition to ultra-low long-term interest rates. The 10-Year Treasury yield fell through the 1.5% floor on February 21st, 2020, then proceeded to decline to as low as 0.398% on March 9th. It was the lowest level ever recorded on the benchmark yield, going back a full century before the end of the last vestiges of the gold standard in 1971.

Most significantly, it remained below its former post-financial-crisis floor throughout the rest of 2020, and all of 2021. Even as inflation rates rose to 7% by the end of last year, the 10-Year Treasury yield remained below 1.5%, and yields throughout the rest of the bond universe remained low as well.

These ultra-low yields were due, in large part, to the Federal Reserve’s decision to backstop corporate and municipal bonds, including the bonds of companies that had been downgraded to junk due to the pandemic. Municipal bonds ended 2021 with an average yield of just above 1%, and AAA-rated corporate bonds yielded just 2.7%. Junk bonds — those at significant risk of default over their duration — offered an average yield of just 3.4%. With such paltry yields from bonds, all of which remained far below the inflation rate, investors and investment managers felt they had no choice but to embrace stocks — even with the broad equity market trading at record valuations.

The cascade of events set in motion from the new era of ultra-low yields in the bond market propelled a buying frenzy in stocks and other risk assets in late 2020 and 2021 as investors scrambled for yield, and the frenzy resulted in the lowest combined yield of a portfolio of U.S. stocks and bonds in history. In July of last year, the cyclically adjusted yield of a traditional 60/40 portfolio fell to 2.13%, the lowest portfolio yield going back to 1881 — lower even than the yields at the speculative peaks in 2000 and 1929. This combined portfolio yield ended 2021 at 2.14%, just one tick above its record low set in July.

The visual history of the yield of the 60/40 portfolio in the chart above reveals that 2021 represented the worst environment in modern history to be invested in U.S. stocks and bonds. When the underlying yield of an investment is near 2%, it takes only a modest uptick in the market’s risk assessment to trigger significant losses.