June 30, 2022
Eric P. Leve, CFA: Linda, thanks so much for sitting down to talk about the bond market. Overall, it’s been a rather shocking first half of the year. The S&P 500 Index’s nearly 20% decline was propelled in part by actions from the Federal Reserve (the “Fed”) to rein in the highest inflation rates seen in decades. This, in turn, drove up borrowing costs for individuals and corporations alike, and made stocks somewhat less attractive relative to fixed-income investments.
One of the most important considerations for investors now is a little different than it might have been six or eight months ago. My question is, can bonds again provide the historical diversification benefits versus equities given the level of yields?
Linda Beck, CFA: As you know, stocks and bonds typically move inversely over longer time periods, which is why a balanced portfolio of stocks and bonds reduces portfolio volatility and is beneficial to investors. 2022 has proven an exception thus far, with stocks and bonds trending together and both posting negative returns. This has been largely driven by two unusual circumstances. First, neither stocks nor bonds were in demand. In riskier times, investors generally turn to bonds in search of lowered volatility. This year, investors reduced their demand for stocks but did not subsequently increase their appetite for bonds due to the very low-rate environment.
Second, beyond the demand equation, investors also acknowledged the rapidly rising inflation and its potentially long-term effects. Generally, longer-dated bonds are more stable, and their value will appreciate as investors price in future lower growth and inflation affecting stocks (as well as short-term bonds). This drives the normally inverse relationship. However, when there is a big jump in inflation—or even just inflation expectations—both asset classes can decline together. If the Fed’s monetary policy can slow inflation without causing major shocks, we could be in a better position for stocks and bonds to regain that inverse relationship. This will allow the bond market to better serve its traditional role as a cushion if stocks continue to deteriorate.
Eric: Given the caveat that 90% of people have gotten inflation wrong at some point in the last couple of years, I’ll ask you this. Do you think the Fed has been behind the curve, or could we have expected anything more of it in this cycle?
Linda: Yes, the Fed has been slow to act, but it had forewarned the markets of its plans to let the economy run hot for a longer period than normal in order to exit the low growth, low inflation environment of the last 20 years. Now, it is clearly playing catch up to maintain economic growth as well as contain inflation as evidenced by its more aggressive monetary tightening. The Fed is in an unenviable position. Trying to navigate a so-called soft landing that doesn’t tip the economy into a recession is very difficult. It is often hard for the Fed to tell that it has over-corrected until it is too late.
Eric: No easy feat. Do you think we’re nearing peak inflation? That is, could the Fed’s job be done in the next six months?
Linda: It’s possible. Some of the cyclical measures of economic health will come in weaker after these significant rate increases, relieving inflation to some degree. However, we might have somewhat stickier long-term inflation, which I believe warrants adjusting the historical 2% inflation goal. If the Fed pushes sufficiently hard to achieve that low of a target, then I’d expect a hard, and not just a soft, recession.
Eric: Indeed, and let’s dive into that a little deeper. Tell me more about your rationale for adjusting inflation expectations up from that historical 2% target?
Linda: The Fed has the greatest control over cyclical inflation, affecting the demand for goods and services. Beyond that, however, there’s three overarching dynamics largely outside the Fed’s purview. To start, the U.S. is experiencing a demographic shift. The baby boomers are retiring, and there’s a smaller proportion of young people entering the workforce. This sets up a long-term tailwind for wage inflation over the next ten years or so.
Next, current conditions regarding commodities also suggest a higher baseline inflation rate. There’s an intense need for core commodities like aluminum, copper, and iron driven by advances ranging from the 5G buildout and energy infrastructure to a spectacular growth in electric vehicles.
Eric: That alone would drive higher long-term inflation. But it’s important to mention that’s also independent of the commodities price acceleration we’ve seen this year due to Russia’s invasion of Ukraine.
Linda: Indeed. And my third and final argument for a higher baseline rate centers on a broad supply chain transformation. In contrast to the past 30 years, which aspired to very tight just-in-time inventory management and sourcing materials from the cheapest foreign source, we are now in a time when we don’t want to be beholden to nations that are geopolitically unaligned with us. We’re willing to pay more to shorten supply lines by producing more goods here in the U.S. Prices are higher, but they do not carry as much of a risk of supply being cut off when relations with foreign suppliers sour. The supply chain shocks related to the pandemic are continuing to work themselves out, but there’s been an overarching shift in the way we manage our supply chain.
Eric: That’s a compelling case for a targeted inflation rate along the lines of 2.5% to 3.5% being more realistic. With that in mind, I’m going to put you on the spot here a bit. What’s your greatest fear right now? Inflation, recession, or stagflation?
Linda: I’d say that runaway inflation is the most worrisome, but I don’t think we’re going down that road. A recession feels in order, however, we don’t yet have both of the usual precursors. Generally, a recession is preceded by slowing economic output combined with a deteriorating job market. The recently released June jobs report was again positive, as the U.S. extended its streak of strong labor-market gains. Regardless, I’m hoping for a normal level of inflation we can all live with. Inflation will most likely be more than we have experienced in the past 20 years but, still, I’m hopeful it does not get out of control or become too entrenched in investors’ psychology.
After this year’s events, the markets and the Fed are viewed with a negative lens. However, the Fed is primarily re-normalizing the monetary environment. It is much healthier for the economy and for investors to have positive bond yields. Over the prior decade, we have suffered very low or, in Europe, even negative yields. With 10-year U.S. Treasury yields closer to 3.5%, we are in a much healthier state, from both a monetary and an investor’s point of view.
Eric: Agreed. That’s a really good point. Ever since the Great Financial Crisis, the Fed has wanted to renormalize policy and has not been able to achieve that goal. This may be a chance to get to a much healthier middle ground that will give the Fed more policy flexibility going forward.
Linda: And for bond investors, they’ve been hit hard this year with unusually negative bond returns. It’s hard to keep in mind that we came off an abnormally low yield base. Now that we’re back up to a more moderate level of yield, bond investors have an income cushion to help offset further price deterioration.
Eric: With respect to those uncommonly negative bond returns, how have corporate and municipal bonds behaved this year? Can you describe the dynamics in those two markets?
Linda: Both corporate and municipal bonds are deemed credit products in the bond world and in 2022 credit risk has started to become more of a concern. Corporate bonds are evaluated on a corporation’s ability to pay back its principal and coupon payments. So as the economy slows down, there’s concern that corporate profits and balance sheets will weaken. This has caused corporate credit spreads to widen significantly this year.
Municipal bonds are impacted by the same economic events as corporates, but with a greater time lag. The credit health for many municipal bonds relies on taxes, so they are in their best shape once taxes are paid. Tax receipts over these last two years have been exceptionally strong, driven by capital gain and sales tax revenue. As we think about portfolio structure over the rest of the year, we believe it makes sense for investors to take a bit more duration, or interest rate, risk but keep credit risk curtailed.
Eric: You’re talking about getting closer to neutral duration. What type of bonds do you think are likely to perform best for the rest of 2022?
Linda: As economic growth slows, we want to hold securities that are highly rated. This includes Treasuries and strongly-rated government bonds as well as select corporate bonds. We’re laser-focused on quality, particularly for our corporate bond exposure. The silver lining is that companies are exhibiting relatively strong long-term fundamentals, as they were just stress-tested through the pandemic.
Eric: Thanks, Linda. We’ll take a silver lining where we can find one! We are perhaps seeing a slowdown in the rate of inflation, but the job’s not done, and indicators of recession continue to rear their heads. In our long-term view, we believe the markets are beginning a journey to a more normalized and sustainable destination. Unfortunately, coming out of a cycle where low rates were artificially maintained by the Fed, it will be a bumpy road with heightened volatility and liquidity challenges. We will continue our focus on quality, with fixed income as a key income generator for diversified portfolios.