What are the historical parallels to past bond market drops and what are expectations going forward?
Is it the mother of all bond market slumps or just a replay of past slumps? Coming up, we follow the drop.
From Thrivent Asset Management, welcome to episode 29 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
The bond market over the last two months has seen the largest increase in yields in 15 years. The widely followed Bloomberg U.S. Aggregate Bond Index is a good proxy for the overall high-grade bond market, measuring the performance of U.S. investment-grade bonds. That index has suffered a total return decline of about 10% year-to-date. That’s worse than many equity market indexes. And long-term Treasury bonds have lost nearly 20% in value in just four short months. These returns are the worst in nearly four decades.
The dramatic shift in rhetoric and policy coming from the Federal Reserve, or Fed, along with the impact it’s had on the bond market, have both been contributing factors behind a dramatic divergence of returns across the equity market. The share prices of high-growth technology companies, which make up a substantial portion of broad market indexes, have declined sharply, with some down 20–40%.
Meanwhile, lower growth and value companies have had positive returns. High dividend-yielding stocks have done particularly well. Excluding REITs, the 100 companies that have the highest dividend yields are up approximately 8% year-to-date.
These sharply negative bond market returns are rare but shouldn’t be a huge surprise after the extreme developments of the past few years. What has been surprising is how long exceptionally low bond yields have persisted.
Yields had fallen to historically low levels due to a long period of low inflation, combined with multiple rounds of quantitative easing, which is a Fed policy that purchased huge amounts of bonds. That move helped hold down yields in addition to causing some technical distortions to the market. During the early and uncertain phase of the pandemic, institutional and individual investors added to the Fed’s bond buying spree in a search for yield and safety.
As they frequently do in the capital markets, these developments went to an extreme when yields fell to levels decidedly below the rate of inflation. And, in an historically new development, yields in many foreign markets fell to 0% and even to negative levels.
As of now, the Fed has executed only one small increase in short-term interest rates. However, it has clearly communicated its intention to continue raising rates in increments of 25 to 50 basis points throughout the rest of the year and into 2023. Given that markets “price in” future expectations, a terminal value next year of about 3% for short term rates is already reflected in bond yields.
Before we continue, now seems like a good time for a short history lesson.
The year 1994 marks the last time the Fed made a surprise hard pivot in policy, raising rates cumulatively by 300 basis points. This provided the catalyst for a bond market crash. The market reaction then was very similar to today, with long-term bond yields rising over 200 basis points while the yield curve – referring to the relationship between 2-year and 10-year maturity bonds – had sharply flattened. The stock market response in 1994 was also very similar to today. After a sustained bull market in ‘93, the S&P 500® Index, representing the average performance of 500 large-cap stocks, declined about 6% in the first quarter of ‘94, while defensive value stocks outperformed.
For the rest of that year, long-term bond yields continued to rise, peaking in December at 8%. Yields then fell steeply in 1995, erasing their entire increase from the prior year. Meanwhile, the S&P 500 remained very choppy throughout ‘94, ending the year with a very modest loss of 1.5%. Then the stock market followed bond prices higher by surging the next year, with the S&P 500 up over 30%.
It’s important to note that when looking at the last bond crash in 1994 – and more importantly, its aftermath – there are some important distinctions.
In 1994, the Fed was moving preemptively to ward off inflation. That year, inflation was running at approximately two and a half percent – roughly the Fed’s current goal – and bond yields were substantially higher at 6–8%. That made the Fed’s interest rate policy tool much more effective in preemptively mitigating inflation.
In contrast, today this relationship between bond yields and inflation is reversed, with inflation readings of 6–8%, while 10-year bond yields are still relatively low at just under 3%. In short, real yields remain decidedly negative.
In our present situation, the Fed is reacting to very high inflation. And many investors believe that the Fed is behind the curve and will need to tighten even more aggressively to contain inflation.
Remember, the key to bond market performance, as always, remains the dynamics of inflation. There are some very preliminary indications that inflation may be coming off the boil. Covid impacts are diminishing. Higher interest rates have begun to affect final demand – especially in housing and autos. And the impact of fiscal stimulus is receding. Supply bottlenecks may also be loosening, although there is limited evidence that this is happening, especially given the impact of the war in Ukraine and lockdowns in China.
If these budding signs of moderating inflation continue, the Fed may be more comfortable with a terminal short-term rate of 3% which, as mentioned previously, is already priced into the market. After such poor performance in the first quarter of 2022, the bond market may be set up to at least earn its coupon return for the balance of the year.
Also remember that it is impossible for the bond market to generate the degree of positive returns experienced after the 1994 bond market crash. Why? For the simple reason that yields still remain close to historic lows at 2–3% as compared to yields in 1994 that were 6–8% percent. The reality is that there still is insufficient current coupon income in the market on which to build meaningful returns.
So, what are the stock market implications of the bond slump of 2022?
We can use the forward price/earnings, or P/E, multiples for the S&P 500 as a simple relative valuation gauge. It’s interesting to note that the current P/E multiple of approximately 19 is only modestly higher than that of the market at this same time of year in 1994. That means that the valuation in the equity market relative to history is reasonable, particularly as corporate earnings continue to be surprisingly robust.
And, as it was during the bond crash environment of ‘94, it’s expected that the stock market will remain choppy through the remainder of the year, or until inflation statistics show signs of abating, or until there’s a favorable resolution to the war in Ukraine.
Subsequent to 1994, falling interest rates powered an expansion in market P/E multiples and thus very high returns. Without the chance for a sustained decline in interest rates, it will be very difficult for the equity market to generate returns close to what they were after the ‘94 bond crash or even those of the past few years. Consequently, returns will be driven entirely by earnings and not from simple P/E expansion. It appears the equity market can grind out modestly positive returns through the balance of the year.
Going forward, significant dispersion of equity returns will most likely persist. Stocks that will continue to outperform in this volatile market will be those of companies with growing earnings, solid profitability, strong balance sheets, reasonable P/E valuation multiples, and clear strategies of returning capital to shareholders through dividends and share repurchases. Excessively valued stocks of high-growth companies, and those with highly leveraged balance sheets, as well as speculative business models, likely will remain laggards.
In short, the most egregious excesses of the cycle are likely over. A return to good, basic fundamental investing will continue to be rewarding for disciplined, patient investors in the coming quarters.
Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. We’d like to hear from you! If you’ve got questions or comments about this episode, or if you have an idea for a topic, email us at email@example.com. You can also learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of April 26, 2022, unless otherwise noted.
Any indexes discussed 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.
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.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.
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