Goldman Sachs sees renewed opportunities for the traditional 60/40 portfolio in 2023; here's why

The year 2022 has been a roller coaster ride for all global markets across the globe. This comes on the back of the Russia-Ukraine war which led to a surge in oil prices and hence inflation. The rise in inflation caused central banks across the globe to raise interest rates.

Stock markets also witnessed massive consolidation on the back of macro growth concerns and recession fears.

In a recent report, global brokerage house Goldman Sachs pointed out that due to the recent re-pricing across stocks and bonds has offered renewed opportunities for the traditional 60/40 portfolio, with potential enhancements available when looking to alternatives.

The 60/40 rule of investing is a tried and tested portfolio allocation formula which says that a balanced portfolio comprises 60 percent of equity and the remaining 40 percent of bonds. This is based on a premise that in the long run, equity gives a higher return while bonds add a stable income to the portfolio.

"Global equities are poised to outperform longer-term, especially with a bottom-up and idiosyncratic focus. Still, higher coupons in fixed income may invite competition for demand with equities. Real asset prices are pulled between demand concerns and structural undersupply, with our belief that the latter will prevail near-term. In our view, the pain of 2022 has given way to an inflection point across markets and regions," said the brokerage.

Inflation

Inflation continues to be the dominant global concern, even in a world of complex geopolitical dynamics that include military conflict in Ukraine, territorial flexing by China, and entrenched societal polarization, noted Goldman. It expects the evolution of inflation and commensurate central bank responses to remain the prevailing theme in 2023. While waiting for the wave to break, however, investors must learn to surf, advised the brokerage.

Recession?

Given the interplay between inflation and monetary policy, many see a recession as a natural byproduct of tighter financial conditions, it stated. History credibly informs such a view, but a US recession may not be a foregone conclusion given a healthy financial system, strong labor demand, and robust private sector, said the brokerage. In the Euro area and the UK, heightened sensitivity to external energy supply makes a recession probable, if not already in progress, it added.

Strategy

"The adjustment to a higher inflationary regime has been painful, with the traditional 60 / 40 portfolio delivering historically poor returns in 2022. Even so, we think the opportunity set has been reset, with fixed income reasserting itself as a critical driver of diversification and cash flow," it recommended.

The brokerage advised investors to adjust their equity exposure in seeking to reflect renewed cross-asset competition by focusing on quality, profitability, and idiosyncratic positioning. In fixed income, it suggests adding duration to address reinvestment risk. Goldman also proposed diversifying existing exposure with alternative investments to potentially access unique sources of returns.

Global Growth

The global economy is likely to grow below trend in 2023 as major central banks continue to tame inflation by normalizing demand, forecasts the brokerage. In Europe, competing tensions between fiscal easing—to buffer the pain of rising energy costs—and monetary tightening will likely determine the duration and magnitude of its recession, it noted, adding that meanwhile, in the US, it believes the path to lower inflation will require right-sizing labor demand and reducing wage growth. Though progress has been made, more restrictive financial conditions may be necessary to help address an overheated economy, noted the brokerage.

Yields

The brokerage also pointed out that the US yields have risen substantially in the past year amid tighter monetary policy. However, it anticipates they may peak as we approach the end of the current Fed hiking cycle. While the 2-Year US Treasury yield has historically tracked the 10-Year yield around the end of prior hiking cycles, the two have diverged in the periods that followed, it noted. Goldman believes such divergence may underscore a nearing challenge for investors: reinvestment risk, particularly on the shorter end of the yield curve. For investors seeking income generation, it believes the relatively stickier yields achieved by extending duration will provide a more durable source of cash flow going forward.

"We recognize that the risk of additional rate hikes may steer investors towards the front end of the curve. Still, that may not always be the case, and the transition may be abrupt. Specifically, at the 24-month mark following the past three Fed hiking cycles, the Bloomberg US Aggregate Bond Index has averaged a yield over double that of the shorter duration index. Additionally, higher starting yields may make any further rate spikes less painful. These future yield advantages are similarly powerful for munis, where we also observe supportive fundamentals. As the calendar flips forward, investors may find attractive yields when adding on duration, across both municipal and taxable bonds," it explained.

Direct indexing

The brokerage further noted that exploiting losses is sometimes easier than building gains. Though the rapid rise in interest rates and the slowing growth backdrop have driven equities lower in 2022, it expects direct indexing may stand to benefit from market volatility.

Direct indexing involves purchasing the underlying shares of an index, rather than owning an index fund. This investment strategy prioritizes tax-loss harvesting, which builds tax savings through capital losses while attempting to keep tracking error tight to the benchmark, explained the brokerage.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of MintGenie.