Investment Strategy

Rethinking the 60/40 portfolio in today’s environment

The 60/40 portfolio — 60% equities and 40% bonds — has long been considered the one-size-fits-all allocation for many investors seeking a balanced allocation, aiming to both capture growth potential from equities and expected income and stability from bonds. The 60/40 portfolio is referenced frequently in financial media and is often used as a benchmark to which investors may compare their performance.

Over the past several years, stock and bond prices have spent more time moving in the same direction than not. With the inverse relationship between bond yields and prices, this means that prices for stocks and yields for bonds have moved in opposite directions for the majority of the time during the Fed’s most recent tightening cycle. This decrease in the correlation between stock prices and bond yields (and increase in the correlation between stocks and bond prices) had made the diversification benefit from the inclusion of bonds in a portfolio somewhat less effective over this recent time period (see chart below).

Chart 1. Short-term correlations between stock prices and Treasury yields have recently moved back positiveSources: Bloomberg and Wells Fargo Investment Institute. Daily data from January 1, 2018, to October 31, 2024. Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than those quoted above. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Short-term correlations between stocks and bonds started to normalize in the second half of this year, signaling that we may see the long-term correlations also move somewhat lower. However, we are unlikely to return to an environment with deep negative correlations between stock and bond prices. Even so, we believe bonds (along with other diversifiers) still play an important role in a portfolio. For investors seeking income, allocations that include fixed income can benefit from the higher income from bonds compared to other yield-generating investments. Commodities and Macro hedge fund strategies have historically had low correlations to both stocks and bonds and may be considered to help diversify assets.

Chart 2. Long-term equity correlation with fixed income remains relatively lowSources: © Morningstar Direct, All Rights Reserved¹ and Wells Fargo Investment Institute. Quarterly data from January 1, 1946, to September 30, 2024. Correlation measures the degree to which asset classes move in sync; it does not measure the magnitude of that movement. There is no guarantee that future correlations between the indexes will remain the same. U.S. equities: S&P 500 Index. U.S. fixed income: Blend of IA SBBI U.S. Long-Term Government Bond Index and IA SBBI U.S. Long-Term Corporate Bond Index until 1976, and then the Bloomberg U.S. Aggregate Bond Index. Commodities: Bloomberg Commodity Index. Macro hedge funds: HFRI Macro Index. Index returns do not represent investment performance or the results of actual trading. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses, or taxes applicable to an actual investment. Unlike most asset class indexes, HFR Index returns are net of all fees. Because the HFR indexes are calculated based on information that is voluntarily provided, actual returns may be lower than those reported. An index is unmanaged and not available for direct investment. Index correlations represent past performance. Past performance is no guarantee of future results.

The basic split of 60% equities and 40% fixed income may be appropriate for those investors seeking a balance of growth and income. But it remains important to consider broader exposure within each of those buckets to help reduce concentration risk. For example, the 60% in the 60/40 allocation need not be entirely U.S. Large Cap Equities. While we have a favorable view of large caps, we encourage both global and market capitalization diversification within the equity asset group. We currently have a neutral tactical position for U.S. Mid Cap, U.S. Small Cap, and Developed Market ex-U.S. Equities.

Alternative assets, such as our favored Equity Hedge Directional strategies, can provide the potential for growth during the stock markets’ ups and downs. Likewise, we suggest that the 40% allocated to bonds not be concentrated in one fixed-income asset. We currently favor U.S. Intermediate Term Fixed Income and have a neutral view of U.S. Long Term and High Yield Fixed Income. Additionally, further building out that diversifier portion of the allocation with Commodities or Macro hedge fund strategies (both favorable under our tactical guidance) can help limit downside participation should periods of short-term stock/bond correlation spikes occur as well as serve as an inflation hedge.

Finally, while the 60/40 may be appropriate for some investors, not every investor has the same goal, objective, or risk tolerance. Investors who have a primary goal of income and a low risk tolerance may find that allocating 60% to equities and other risk assets exposes them to too much risk and not enough income to meet their goals. On the other end of the risk spectrum, an investor with a higher risk tolerance who is primarily seeking growth may feel a performance drag from allocating 40% to fixed income and diversifiers. In both of those cases, defaulting to a 60/40 mindset may not be appropriate, and those investors may seek to better tailor their allocation to their objectives instead of employing a one-size-fits-all solution.

¹ All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

Small caps sprint ahead of fundamentals

As of November 12, the Russell 2000 Index, which represents U.S. small-cap companies, was up around 20% from its low on August 5, with about half the gains coming after Election Day. In our opinion, much of the rally, especially post-elections, is due to improved sentiment as investors view a red sweep (Republicans winning the Presidency, Senate, and House) as better for smaller companies. Specifically, they view the higher possibility of greater U.S. production of manufactured goods, lower taxes, and less regulation, which are stated goals of President-elect Trump, as presenting a better operating backdrop for these companies.

While that may be true, consensus estimates¹, based on a compilation of analysts that know these companies, continued to fall. In fact, consensus estimates for the Russell 2000 Index now sit at year-to-date lows and are almost 15% below the final earnings number reported for 2023. This sharp divergence between price and fundamentals will eventually have to be reconciled, and potential setbacks or disappointments in the policy rollout could lead to a sharp pullback in the Russell 2000 Index. We believe now would be a good time for disciplined investors to make sure that their portfolio allocations are not above recommended allocations, as we maintain a neutral rating on the asset class.

The chart below suggests that the Russell 2000 Index (2392) remains in an uptrend but is overbought. On pullbacks, it should find support at the 50-day moving average (2224), followed by the 200-day moving average (2108). Resistance on the way up will likely be found at the late-2021 high (2443).

Small caps appear overdoneSources: Bloomberg and Wells Fargo Investment Institute. Daily data from November 12, 2020, through November 12, 2024. RTY = Russell 2000 Index. SMAVG (50) = 50-day simple moving average. SMAVG (200) = 200-day simple moving average. RSI = relative strength index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

¹ 2024 consensus estimates for Russell 2000 Index earnings per share.

November cut offers few answers on path of rates

On November 7, the Fed delivered another 25-bp interest rate cut, continuing a rate-cutting cycle that began with a 50-bp cut at its September meeting. Chairman Jerome Powell was tight-lipped on the Fed’s future plans during his press conference, and unlike at its September meeting, the Fed did not provide a Summary of Economic Projections detailing committee members’ expectations for future rate cuts.

While this meeting offered few surprises, questions have arisen on future rate cuts. Powell did mention that the rate of inflation has fallen significantly, but strong economic readings and sticky core inflation have weighed on market sentiment. Market expectations for a December rate cut have fallen considerably over the past months.² While we continue to project one additional 25-bp rate cut in December and three total in 2025, we believe the risks remain to the upside for rates.

Though the potential for less rate cuts and a hotter economy remains, we still see opportunities in longer-maturity bonds. The chart below shows the 10-year U.S. Treasury yield’s rise of almost 70 bps since the Fed’s September meeting, putting yields at an attractive level relative to their 20-year averages. While we see the potential for yields to move higher, the economic data and election in recent months have highlighted long-term fixed income as a potential investment for excess cash and cash equivalents. Given our expectation for falling yields in short-term fixed income and cash equivalents, turning to current yields on long-term bonds may replace yield generation as the Fed cuts rates.

10-year U.S. Treasury yields since September 2024Sources: Bloomberg and Wells Fargo Investment Institute. Data as of November 11, 2024. Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than those quoted above. Past performance is no guarantee of future results.

² Bloomberg Fed Funds Futures pricing as of November 11, 2024.

Slowing oil capital expenditures should be good for oil prices in 2025

Global crude oil prices have been pressured lower this year amid concerns over weakening demand and the potential for stronger global supply growth. As of November 11, Brent crude oil and West Texas Intermediate (WTI) are sitting at $72 per barrel and $68 per barrel respectively, providing attractive upside to our 2025 year-end targets. We are positive on oil prices in 2025 because we believe that global oil demand will be better than most expect and global supply growth will be slower.

Slower supply growth, especially, we believe will be the main driver of higher prices. Global producers are practicing better capital discipline as we exit 2024 — returning profits to shareholders versus growing capital expenditures. One way to view this is the red line in the chart, a ratio of capital expenditures to cash flows generated from operations for the MSCI ACWI Global Energy Sector. We’ve inverted this ratio to show its connection to future oil price movements (purple dashed line). The falling red line indicates that producers have been expanding their ability to explore and drill for more oil — relative to the cash flow that they are generating from existing oil fields. Producers do this when they believe prices are high enough to warrant the added risk of locking-up additional capital to produce more oil.

Now in November 2024, with oil prices in the low $70s, the extra profit potential has evaporated for many. Recent data has signaled better capital discipline, and we view this as a sign that global supply growth could be slower than market expectations in 2025. Therefore, we remain most favorable on the Energy sector, and we expect oil prices to move higher in 2025.

Low capital expenditures could support higher oil pricesSources: Bloomberg, Macrobond, and Wells Fargo Investment Institute. Quarterly data is from March 31, 2000 - September 30, 2024. YoY = year-over-year. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Direct lending continues to gain traction

Private debt managers are on track to record the fifth consecutive year that global institutional fundraising exceeds $200 billion, according to Pitchbook. The direct lending strategy remains a major driver of this trend, with the strategy now accounting for over 50% of private debt’s asset under management.

Direct lending’s popularity has also grown among wealth management investors, where the strategy is typically offered through registered perpetual capital vehicles. These perpetual funds allow monthly subscriptions and redemptions and offer greater accessibility and transparency relative to traditional options. Nevertheless, as private market investments, direct lending funds are generally designed for long-term qualified investors. Based on Pitchbook data, direct lending has garnered over 50% of the assets raised by perpetual private capital funds over the first half of the year.

As shown in the chart below, direct lending is on the verge of surpassing the $1 trillion mark in assets under management, and we believe there remain opportunities for growth given direct lending’s small share of total corporate borrowing.

We also have observed direct lending’s resilience in its recent interplay with bank loans. Traditionally, banks issued syndicated loans to finance large buyout transactions, whereas direct lending generally focused on the smaller deals. As banks gradually withdrew from corporate lending due to regulatory scrutiny, and in recent years the slowing economy, direct lenders moved in and expanded their businesses. As bank loans came back this year, direct lending was able to maintain its momentum in issuing new loans and refinancing existing credits by offering borrower-desired timeliness, certainty, and competitive pricing.

Although direct lending managers currently need to successfully manage credit risks especially with lower-quality, smaller borrowers, we believe our expectations for an upcoming economic recovery and growth, improving corporate credit conditions, and the desired features that direct lending offers to continue to support its growth over the long term.

Direct lending approaches $1 trillion in assets under managementSources: Pitchbook, the Federal Reserve, and Wells Fargo Investment Institute. Data as of December 31, 2023. AUM = assets under management.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, November 18, 2024.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Please see end of report for important definitions and disclosures.

Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation, and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Bank loans are subject to interest rate and credit risk. They are generally below investment grade and are subject to defaults and downgrades. These loans have the potential to hedge exposure to interest-rate risk, but they also carry significant credit and call-risk. Call risk is the risk that the issuer will redeem the issue prior to maturity. Although Treasuries are considered free from credit risk, they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt, and private real estate funds, are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation, and higher fees than mutual funds. Hedge fund, private equity, private debt, and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives, and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty, and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Bloomberg Commodity Index is comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

HFRI Macro Index: Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed-income, hard currency, and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.

Note: HFRI Indices have limitations (some of which are typical of other widely used indices). These limitations include survivorship bias (the returns of the indices may not be representative of all the hedge funds in the universe because of the tendency of lower performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately reflect the performance of a described style); and limited data (many hedge funds do not report to indices, and, therefore, the index may omit funds, the inclusion of which might significantly affect the performance shown. The HFRI Indices are based on information self‐reported by hedge fund managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, L.L.C. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe and may be biased in several ways. Returns of the underlying hedge funds are net of fees and are denominated in USD.

IA SBBI U.S. Long-Term Corporate Bond Index is a custom index designed to measure the performance of long-term U.S. corporate bonds.

IA SBBI U.S. Long-Term Government Bond Index is a custom index designed to measure the performance of long-term U.S. government bonds.

MSCI ACWI Global Energy Index includes large and mid cap securities across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. All securities in the index are classified in the Energy as per the Global Industry Classification Standard (GICS®).

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

S&P 500 Index is a market-capitalization-weighted index considered representative of the U.S. stock market.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) and Global Manager Research (GMR) are divisions of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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