Over the past few months, the Fed has made it clear, both in word and deed, that controlling runaway inflation is its top priority. Unfortunately, the Fed’s series of rate hikes didn’t help traditionally balanced portfolios while hurting stocks and bonds – a historic rarity. Not only are interest rates rising, but they are expected to stay high for some time.

In light of these developments, it was inevitable that my portfolio construction team and I would ask questions that fell under one of two themes:

When will the pain stop?

Is a balanced portfolio obsolete? To give an exact answer to the first question would be the height of arrogance, but at some point the Fed will outpace inflation, probably in 2023 – and probably during a mild recession. But a recession is not necessarily a bad thing for the balanced investor. In fact, it will mark a new beginning.

A bright future for fixed income securities

If the Fed’s aggressive actions are ultimately rewarded, we should see continued gradual declines in inflation. According to this baseline view, the Fed will stop raising interest rates in 2023 and a major source of market uncertainty will disappear. The onset of a recession is usually accompanied by rising bond prices and falling yields, especially among longer-dated bonds. The exceptionally positive return correlation we have seen this year between equities and bonds could be on the decline, ending the downward spiral for both asset classes. Which brings me to my second question:

No, a balanced portfolio is far from obsolete.

When that happens, fixed income securities will resume their role as a buffer for equities. There is another factor in favor of bonds and a balanced portfolio:

Interest rates are likely to remain high even if inflation slows, which could end years of negative real (inflation-adjusted) fixed income rates. We are about to enter a period of positive real interest rates, which strengthens the case for fixed income securities.

If history is any indication, the patience of balanced investors will pay off:

Never in the past half-century has the traditional 60/40 portfolio experienced a three-year period of negative returns on stocks and bonds. We don’t yet know where the bottom is, but investors exiting now will miss the rally.

Stocks approach fair value

Based on guidance provided by the Federal Reserve on the likely path of interest rates, we can reasonably predict the path of fixed income performance, if not necessarily the exact timing. Inventory forecasting is more difficult, but there is still room for cautious optimism over the medium term. At the start of the Fed rate hike cycle, US stocks were overvalued:

The Shiller P/E ratio for the S&P 500 at the end of 2021 is more than 30% higher than our estimate of the fair value of the S&P 500. This year’s slowdown means we are now more in line with averages at long term.

Those hoping for a V-shaped recovery may be disappointed that stock prices rebound as strongly as they fell in early 2009 or more recently in March 2020. In some respects, we are closer to 1999 market conditions. -2000, when equities were overvalued and the ensuing fall only pushed valuations closer to long-term averages. Yields eventually normalized after the dot-com crash, but the market failed to rebound. The current low market valuation favors higher expected returns. Our model predicts 10-year annualized returns for US and non-US equities that are nearly 2 percentage points higher than a year ago, but still below long-term historical averages.

The recent strengthening of the dollar – driven by the Fed’s aggressive interest rate hikes relative to other central banks, combined with the natural flow into US Treasuries during the global crisis – means that non-US investment returns will be weak in the short term. Compared to investment conditions in the United States. However, in the longer term, we expect these two drivers of USD strength to reverse, helping non-US equities.

Overall, return expectations for balanced portfolios are gradually returning to historical averages as the outlook for fixed income and equity markets improves. Maintaining balance and diversification across asset classes and borders remains a prudent exercise for most investors.