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The bond slump of 2022 [PODCAST]
What are the historical parallels to past bond market drops and what are expectations going forward?
What are the historical parallels to past bond market drops and what are expectations going forward?
05/17/2022
MARKET UPDATES
The shocking and tragic reality of an invasion and ground war in Ukraine adds yet another dimension to the economic tumult of the past five years.
During this short time frame, there have been two presidents with vastly different agendas, a trade war, significant tax policy changes, a global pandemic, social/political discord, a severe but incredibly short recession, unprecedented government spending, and a stock market collapse followed by an historic rally. Up to now, financial markets have been amazingly resilient, generating unexpectedly high returns over the past five years.
Against this tumultuous backdrop, inflation remained surprisingly muted and consistent, oscillating in a narrow range around 2%. It was this constant that allowed the Federal Reserve (Fed) to maintain accommodative monetary policies, some of which originated in the great financial crisis of 2008, and to provide copious amounts of liquidity during the pandemic crisis. The surprising economic resiliency and stock market gains can, in large part, be credited to muted inflation and Fed policies.
For many years there have been critics of the Fed who believed that easy money policies would eventually lead to an inflation problem when too much money chased too few goods. However, like the boy who cried wolf, these concerns never materialized – until now.
Inflation statistics continue to be quite disconcerting, with the most recent Consumer Price Index (CPI) reading of 7.5% on an annualized basis. Speculation that these hot inflation numbers were transitory, or were being overly influenced by supply chain issues that would clear up as the economy reopened, have now faded. Now, war in Europe is causing commodity prices to soar and supply uncertainties to increase, magnifying concerns over inflation.
As inflation statistics proved “sticky,” the Fed responded with a clear change in its policy rhetoric, as it signaled its intent to raise short-term rates over the coming years. In addition to increasing short-term interest rates, the Fed also indicated it would wind down its large bond buying program. The goal is to raise interest rates in order to moderate excessive demand that is adding to inflationary pressure.
This relatively sharp monetary policy pivot, in response to building inflationary pressures, led to significant volatility and declines in the stock and bond markets. It also added to the underlying anxious environment that has prevailed since the pandemic began. The shock of a ground war in Europe now adds fuel to this anxiety.
The Ukrainian situation now presents a new problem for the Fed due to the impact that severe financial sanctions may have on global payment systems, liquidity and, ultimately, the stability of financial markets. Consequently, the Fed will need to factor this new reality into its policy initiatives that were expected to begin in March.
Traditionally, when the Fed pursues tightening policy measures, the economy tends to slow and, oftentimes, eventually declines into recession. Bond prices typically decline (with rising interest rates) and stock prices can, but not always, falter eventually. Investment decisions are thus more challenging. However, some of the conventional thoughts on investing when inflation is moving up may provide only minimal benefits.
First, it is necessary to determine if this very recent inflationary spike will be durable, warranting significant changes in investor portfolios. Making this assessment is quite a challenge given that inflation has averaged just 2.3% over the past 30 years, rarely rising above 4%, and in some periods hovering near zero! Not long ago, there was a pervasive feeling that deflation was a serious potential risk.
Second, there is a credible argument that the current inflationary impulse is due to pandemic induced supply shocks that should recede over time. Thus far though, there is little evidence that supply problems are abating.
Finally, the effects of a potentially drawn-out war in Europe are difficult to assess, given that there has not been a development like this since World War II.
Conventional approaches to defending a portfolio from inflation typically focus on commodities (especially gold), Treasury Inflation Protected Securities (TIPS), and real estate. Although these may have a place in a well-diversified portfolio, excessively reallocating a portfolio to these areas can detract from long term wealth accumulation:
Worries over inflation typically lead investors to consider the “alternative” investment areas of commodities, gold, TIPS, and real estate. But, common stocks, which represent the core asset class for most investors, have historically generated reasonable long-term returns, relative to these alternative areas, even in an inflationary environment. Over longer periods of time, common stocks have typically generated meaningfully higher returns than most inflation hedging “alternative” assets.
However, an inflationary environment provides unique challenges for corporate management teams to generate returns for shareholders. Managing costs, efficiently allocating capital, and astutely managing balance sheets becomes paramount. Companies that demonstrate these virtuous characteristics, regardless of capitalization size, have recently been differentiating themselves relative to the overall market in terms of their stock performance.
It has been decades since inflation was truly a problem for the U.S. economy. Many secular forces have been responsible for keeping inflation muted, thus investors should be mindful of not overreacting to this recent surge in inflation. Currently some of these secular forces have waned, and the huge amount of liquidity that has been pumped into the economy is a legitimate cause for concern that investors should consider in weighing the impact of inflation on portfolio allocation. The tragic events in Ukraine also may add to the potential for inflationary pressures to persist. However, some of the conventional alternative asset classes that are thought to provide meaningful protection against inflation may not provide enough of an advantage to warrant dramatically altering a portfolio.
In addition to inflation considerations, investors should be mindful of the impact of past geopolitical events on markets. Since the start of World War II, the median duration of a selloff in the S&P 500® following a major event was 15 days with an average drawdown of about 6%. The average duration of a recovery from this decline is about 16 days. (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)
Markets on average have histoically recovered relatively quickly from geopolitical events such as armed conflicts and politics. The odds are stacked against most investors being nimble enough to execute tactics in their overall portfolios to take advantage of such short-term market action.
A well-diversified portfolio certainly can include gold, TIPS, and REITs, as well as other assets that may marginally perform better in a more inflationary or crisis-oriented environment. But making significant allocations to these areas at the expense of core equities in hopes of gaining significant protection from inflation or geopolitical turmoil is likely to result in diminished long-term performance.
The market has begun to clearly differentiate between quality companies and more speculative “profitless” companies. As interest rates rise in concert with rising inflation, valuation now becomes much more important. Fundamentals, solid business plans, cash flow, and dividends are again relevant rather than disruptive innovators, “blank check” initial public offerings and cryptocurrencies.
All information and representations herein are as of 03/04/2022, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
Past performance is not necessarily indicative of future results.