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Post: Market Extra: Stagflation is raising the risk of `lost decade’ for 60/40 portfolio of stocks and bonds, Goldman Sachs says

Rising stagflation risks in the U.S. and Europe are raising the possibility of a “lost decade” for the 60/40 portfolio mix of stocks and bonds, historically seen as a reliable investing choice for those with moderate risk appetites.

Such a “lost decade” is defined as an extended period of poor real returns, says Goldman Sachs Group Inc.

portfolio strategist Christian Mueller-Glissmann and his colleagues, Cecilia Mariotti and Andrea Ferrario. Since the start of 2022, 60/40 portfolios in the U.S. and Europe are down more than 10% in real terms, they wrote in a note released Friday.

The risks of slower growth plus inflation are being amplified by the Russian invasion of Ukraine, and are already taking a toll on many investors. The three major U.S. stock indexes are off by 5% to 12% this year, with the tech-heavy Nasdaq Composite COMP dropping the most. Meanwhile, bonds are also having a rough time — with the 10-year Treasury note

putting in its worst year-over-year performance since 2013 as of Thursday, which has pushed its yield above 2.1%. That’s diminished the performance of the 60% allocation to equities and 40% allocation to bonds.

Signs of stagflation worries are evident in rates markets. The 10-year U.S. breakeven inflation rate, a gauge of inflation expectations, has reached its highest level since the 1990’s, according to Goldman Sachs. Meanwhile, inflation-adjusted real yields remain near their lowest in decades, reflecting pessimism about economic growth in coming years. And the widely followed spread between 2-

and 10-year Treasury yields is inching its way closer to an inversion, typically a harbinger of recession.

Datastream, Haver Analytics, Goldman Sachs Global Investment Research

“The number one problem with the 60/40 portfolio is that the pace of inflation means real returns on the bond side will be negative,” said John Silvia, founder and chief executive of Dynamic Economic Strategy in Captiva Island, Florida. “And slower economic growth means slower profit growth, which means the stock side of the portfolio gets hit as well.”

“So the total portfolio performance will probably be disappointing relative to past years, and it could entirely last a full decade,” Silvia said via phone. “The reason is that you’ve had arbitrarily low interest rates for four to five years, and a lot of speculation in the market place with people reaching for yield. The demise of the 60/40 portfolio has been a long time coming and it’s finally here.”

The lost decade envisioned by Goldman Sachs marks a turnabout from the last cycle, which benefited from what Mueller-Glissmann and his colleagues call a “structural ‘Goldilocks’ regime.” That’s when low inflation and real rates boosted valuations and profit growth, despite relatively weak economic growth. Equities and bonds each performed well side-by-side — with real returns on the 60/40 mix producing a roughly 7% to 8% return each year during the last cycle, compared with a 5% long-run average, they said.

The thinking behind the 60/40 mix in the first place has been the notion that bonds can act as a ballast to the riskiness inherent in equities. Private pension plans are one group of investors who continue to cling to the mix, and have “rarely deviated from it,” according to Deutsche Bank researchers.

But lost decades are more common than many think, according to Mueller-Glissmann, Mariotti and Ferrario. They’ve occcurred during World War I, World War II and the 1970’s — following strong bull markets marked by elevated valuations. And the chances of a lost decade rise in the face of stagflation, they said.

The following chart reflects 1-year and 10-year drawdowns in the 60/40 portfolio through the decades.

Datastream, Haver Analytics, Goldman Sachs Global Investment Research

A combination of other investments can help reduce the risk of another 60/40 lost decade for investors, the Goldman team said. They include allocations to “real assets” such as commodities, real estate, and infrastructure — as well as greater diversification in overseas markets. Investors should also consider value and high-dividend-yielding stocks, as well as convertible bonds, according to Goldman.

On Friday, most Treasury yields continued to fall, led by drops in the 20-year and 30-year bond rate BX:TMUBMUSD30Y, as investors factored in the prospects of slower growth.

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