East Bay Investment Services, has some thoughts on the current economic and market conditions.
It is understandable that savers, spenders, and investors might all be concerned with inflation readings in the 8-9% range. In particular, if that level is sustained, how will households maintain their standard of living, and what kind of portfolio can generate returns that could keep up? While we can’t say for sure and don’t make predictions, if we look to guidance from the bond market, the present consensus points to a 2.9% inflation rate over the next 5 years, and 2.6% over the next 10, according to the breakeven inflation rates published by the St. Louis Fed. While it might sting in the short term, these readings imply that the market thinks the Fed can rein inflation in using the tools at its disposal.
That said, there are forces contributing to inflation outside any single entity’s control, namely on the supply side. In particular, the war in Ukraine’s impact on energy costs and supply chain problems stemming from China’s COVID lockdown policies and other aspects of the pandemic, which, oh, by the way, is still with us. In regard to energy, we are already seeing policy responses to help fill the vacuum of Russian and Ukrainian supplies, but we know it takes time to bring new sources and delivery mechanisms online, so it may still be months before prices come down in any meaningful way. Another element fueling the fire has to do with pent-up demand for goods and services during the “lockdown” as well as the spend-down of the huge savings that Americans collectively set aside during the stay-at-home economy; these forces will eventually normalize.
Given all the stimulus and with the Fed having kept rates at zero for as long as it did, it is understandable that we have inflation, although it now seems less temporary than originally expected. We see it as an unfortunate side effect of the necessary remedy for the chief economic problem of its time. If the signals are correct that inflation will moderate, perhaps the best tool at households’ disposal is to defer unnecessary discretionary expenses to make room in the budget for higher costs on essentials. It may also be wise to check the calculus on the projections for clients most vulnerable to inflation just in case the problem persists. While there is no panacea among investment options, for clients needing inflation protections we still feel short-term TIPS are the purest hedge.
The Death of the 60/40 Portfolio
You have undoubtedly fielded questions or read articles questioning whether bonds have forever lost their ability to protect portfolios in periods of stock market declines. To this we would respond with a resounding “No!,” and we can examine the recent environment to illustrate how it has been different from prior ones. Historically, stock market declines are kicked off due to factors like over-speculation and subsequent bursting of bubbles like in the dot-com and housing scenarios, or other externalities. In this environment, investors’ appetite for risk falls off, so they sell stocks (and other risky assets) and head for the safety of bonds (among other things), which is why bonds generally do well in a market crash.
The difference this year is that the “risk” actually materialized in the bond market first when the Fed started to raise rates to combat inflation. Bond prices are immediately and directly impacted by rising rates because existing bonds at lower yields are instantly less attractive than newly-issued bonds. Rising interest rates also negatively affect stocks for a few reasons, including the increased cost of capital that companies now have to deal with, and the fact that stock prices are in part determined by discounting their expected future returns; a higher discount rate means a lower present value of future returns. Unless you believe interest rates are going to be on a permanent upward path (as stated above, this would be an opinion not shared by the market at large), it is unlikely we will continue to see declines in both stocks and bonds of the magnitude we have seen year to date.
Importantly, the fact that bond prices have come down, and yields have risen, means that bonds’ potential to do well in a downturn has increased. For an oversimplified example, a bond with a duration of 6 yielding 1% that goes down to 0% will only net a holder of that bond a 6% return; a bond with a 6-year duration yielding 3% that goes to 0% nets that investor an 18% return. This, plus the increased yield on bonds while we hold them, is a silver lining of the recent bond market selloff.
Similar to the inflation story, we should not be surprised to see declines in asset prices. When COVID struck, the stock market fell, only to recover when government stimulus kicked in. It shouldn’t be a surprise, then, that some air is let out of the sails when that stimulus is subsequently removed.
While we aren’t trying to paint a rosy picture, and we aren’t saying we are out of the woods yet, we are just trying to put some rationale behind what we are seeing in the headlines recently.