The Fed's impact on the balanced portfolio

The Federal Reserve has made it clear in recent months, in both words and action, that reining in runaway inflation is its top priority. Unfortunately, the Fed's series of interest rate hikes have not been helpful for the traditional balanced portfolio, hurting both stocks and bonds—a rare occurrence historically. And rates will not only go higher but may stay elevated for a while.

Inevitably, given these developments, my portfolio construction team and I have been fielding questions that fall under one of two themes:

• When will the pain end?
• Is the balanced portfolio obsolete?

To give an exact answer to the first question would be the height of hubris, but at some point the Fed will get ahead of inflation, probably sometime in 2023—and most likely amid a mild recession. But a recession isn't necessarily a bad thing for the balanced investor. In fact, it will mark a new beginning.

A brighter outlook for fixed income

If the Fed's aggressive actions finally pay off, we should see inflation continue its gradual move downwards. Under this baseline view, the Fed will stop hiking rates in 2023, and a key source of uncertainty in the markets will dissipate.

The beginning of a recession is usually accompanied by bond prices going up and yields going down, particularly at the longer end of the maturity spectrum. The unusually positive return correlation we've seen this year between stocks and bonds may fall, and the lockstep downward spiral of the two asset classes could end. This leads me to answer the second question: No, the balanced portfolio is far from obsolete.

When all this comes to pass, fixed income will resume its role as a buffer for equities. And there's another factor in favor of bonds and balanced portfolios: Interest rates are likely to stay elevated even as inflation moderates, likely ending many years of negative real (inflation-adjusted) rates in fixed income. We're on the verge of entering a period of positive real rates, strengthening the case for fixed income.

If history is any indication, the patience of balanced investors will pay off: Over the past half-century, the traditional 60/40 portfolio has never had a three-year period with negative returns for both stocks and bonds. We don't yet know where the bottom is, but investors who get out now will miss the rebound.

Stocks closer to fair value

Based on the guidance the Fed has provided regarding rates' likely path, we can reasonably project the performance trajectory of fixed income, if not necessarily its exact timing. Projections for stocks are tougher to do, but there is room for cautious optimism over the medium term. At the beginning of the Fed's hiking cycle, the U.S. stock market was overvalued: The Shiller price-earnings ratio for the S&P 500 Index at year-end 2021 was more than 30% above our estimate of the S&P 500's fair value. This year's downturn means we're now more in line with the long-term average.

Those hoping for a V-shaped rebound, where stock prices bounce back as sharply as they fell—like in early 2009 or, more recently, March 2020—may be disappointed. In certain ways, we're closer to the market conditions of 1999–2000, when stocks were overvalued and the subsequent plunge only brought valuations closer to long-term averages. After the dotcom bubble burst, returns eventually normalized, but there was no market bounce.

The market's current lower valuations have the upside of increased expected returns. Our models project 10-year annualized returns that are almost 2 percentage points higher than a year ago for both U.S. and non-U.S. stocks, though still below long-term historical averages.

The recent strengthening of the U.S. dollar—driven by the Fed's aggressive rate hikes relative to other central banks, on top of the natural flight to U.S. Treasuries during times of global crisis—means that returns for non-U.S. investments will be muted over the short term relative to U.S. investments. Long term, however, we expect these two drivers of the U.S. dollar strength to reverse, which would help non-U.S. stocks.

Overall, with improved outlooks for fixed income and stock markets, return expectations for a balanced portfolio are gradually normalizing back to historical averages. For most investors, staying balanced and diversified across asset classes and borders remains a prudent course.

Notes:

• All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future returns.
• Investments in bonds are subject to interest rate, credit, and inflation risk.
• Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.