A sunnier climate for bonds?

It has been a torrid past few months for both bonds and shares, a somewhat unusual scenario. Going forward their performance could diverge more, making it easier to construct a balanced portfolio.

| 7 min read

Diversification – spreading your money around a variety of different assets – is widely seen as the cornerstone of sound investment. It’s not sensible to pin all of your hopes on one company, one sector or even one asset class if you want your wealth to stand the test of time – no matter how appealing it might seem.

A balance between the ‘big two’ asset classes, equities and bonds, has been especially beneficial historically in terms of ironing out volatility in a portfolio. In good economic times equities typically performed well and bonds tended to languish, albeit producing a useful income along the way. Then, in more difficult times, capital values of bonds often rose as interest rates were cut, while share markets usually suffered a downturn as company profits contracted.

Inflation shock

Yet the customary ‘self-balancing’ of a traditional equity and bond portfolio has broken down in recent times, largely thanks to the trajectory of interest rates, which were cut to close to zero to provide much-needed economic support during the Global Financial Crisis, and then again during the onset of Covid pandemic. This, along with substantial money printing from central banks, boosted bond and equity markets together. Cashflows from both were seen through the lens of continual subdued inflation and interest rates, meaning investors were willing to pay more for them.

The recent inflation shock has therefore dealt a considerable and unexpected blow to portfolios. As expectations of a period of higher and longer-lasting price rises intensified, bond and equity markets suffered in tandem. 2022 has thus far been a perfect storm, a period in which almost nothing in a traditional, diversified portfolio has been able to produce a positive return. Some helpful outliers have been found in ‘real assets’ such as commodity stocks, infrastructure and some property where a prospective income more resilient to the threat of inflation has attracted investor interest, but these have been few and far between.

The outlook remains difficult

In the short term, things might not get much easier for investors. Central banks underestimated the inflationary impact of money creation during the Covid era, wrongfooted perhaps by the patchy and intermittent economic recoveries from lockdowns. They could hardly have foreseen, nor can they do anything about, the compounding effect of the Russian invasion of Ukraine, which has driven up energy and food prices further. Yet now they are determined to vanquish inflation, and that means higher interest rates, potentially for some time to come.

The fear now is that they go too far the other way, raise rates excessively and cause a damaging economic downturn. There is a need for central banks to talk and act tough to combat yearly price increases that have soared to almost double-digit percentages on both sides of the Atlantic. There is also a worry that as wages continue to rise to compensate workers for the cost of living, it could create an upward spiral of income and prices. But it is also possible authorities could overshoot and cause more economic malaise than necessary in their desire to reign inflation in.

Some good news for the central bankers comes from signs that inflation is starting to peak.

Some good news for the central bankers comes from signs that inflation is starting to peak. Wage inflation is certainly coming through but is a long way behind consumer prices, and this has contributed to very weak confidence among consumers. We can therefore expect difficult times ahead for many businesses as demand subsides, a chance of recession and a future period when interest rates might be cut, provided inflation comes back down quite quickly. This seems likely, partly because the big numbers in the price indices become the new bases from which to measure.

In a recession, companies lose turnover and profits, so the equity market would likely be under some pressure in this scenario, a gloomy one perhaps for equity investors but possibly a brighter one for those holding bonds. The fixed level of income from bonds would start to look more appealing as the inflation cycle and interest rate cycle peaks, although investors will need to take account of any deterioration in creditworthiness, especially in relation to higher risk, higher yield debt.

Rays of sunshine

We may now, therefore, be reaching a time when the diversification benefits of owning bonds alongside equities starts to reassert itself. Once there are firmer signs of inflation topping, share markets may respond more positively to good economic news, bonds to a deterioration. It won’t necessarily make things easy. Interest rates could remain higher than they have been for the past decade. Outsized, broad-based annual gains caused by loose-money policies could well be a thing of the past, but effective portfolio diversification should at least be easier to achieve now there has been a period of painful adjustment.

At the turn of the year, markets were anticipating very modest short-term interest rate hikes by the US Federal Reserve, the world’s most important central bank, with a bit more to come in 2023. A gentle tap on the brakes.

From this perspective, the worst could be behind us.

However, markets that have rapidly adjusted expectations are now prepared for multiple hikes from the Fed in steps of 0.5% to 0.75%, more of an ‘emergency stop’. Its latest ‘dot plot’ revealing the expectations of members for rates by the year-end shows an average of 3.4%, a huge shift from the sub-1% that was widely projected at the turn of the year. Other central banks have shifted stance too, to a greater or lesser degree, and it has caused the largest upward move in yields since 1994. From this perspective, the worst could be behind us. Bonds are priced more realistically for the risks of inflation on the one hand and economic contraction on the other.

A more usual scenario of the bond market zigging while the equity market is zagging helps investors control volatility in portfolios and assists them in delivering decent returns in a variety of scenarios. While there may be some near-term volatility affecting both equities and bonds as inflation expectations ebb and flow, it may be a good time to consider bond exposure with the view that it helps guard against the possibility of recession and a sharp fall in inflation that may turn out to be better for fixed income investments than it is for company earnings. Stubborn inflation requiring yet more interest rate rises than predicted, or higher rates for longer, would present a more difficult scenario for bonds – and for equities – but this would not seem as likely. We believe bonds could once again provide more of a buffer in portfolios as we move through the year.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

A sunnier climate for bonds?

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