Discipline Amidst Uncertainty

For instance, the NASDAQ was off from the start of the year almost ~20% and the S&P ~12.5% in mid-March, recovering a few percentage points since that time. As of this writing the broad bond market, as measured by the Barclays Aggregate Bond Index, is off over ~9%, which is one of the worst starts to any year for the bond market. This is a bit surprising, as normally bonds provide protection and even gain in value during sharp (>10%) stock market declines like those we’ve seen this year. This is especially true of U.S. government treasuries, which so far in 2022 have done even worse than the broader bond market at longer maturity levels.

Typically, as shown in the table below, treasuries have gained value during notably sharp stock market declines as investors fled to “safe” government backed investments. But not this time, at least so far. If stock markets continue to decline materially from here, it is your CWM team’s expectation that these assets will eventually gain some positive pricing traction as inflation concerns take a back seat to the stock market fears that historically benefit the bond space. 

Source: Inker, B. (Q2 2020). Government Bonds Have Given Us So Much: Do They Have Anything Left to Give. GMO

It is also worth noting that the odds of an economic recession have been rising, and recessions are typically a good environment for bonds, with a 100% positive price movement of the asset group in every instance since 1929.

Source: Student of the Market. (April 14, 2022). Blackrock.

The reason to own bonds then, like treasuries, is because historically they’ve provided protection during strong market declines and economic recessions, both of which are currently expected based on a history of similar data sets and market conditions.

Malfunctioning Safety

Traditional safe assets have not held up as well as usual in the current negative stock market scenario mainly because of 40-year high inflation levels, which are directly related to COVID-19 shutdowns, supply chain disruption, and the war in Ukraine, amongst other world events. Inflationary pressures remaining high longer than expected has resulted in investors pricing in a more aggressive Federal Reserve (Fed) interest rate response.

Source: Smialek, J. (April 12, 2022). Inflation Hits Fastest Pace Since 1981, at 8.5% Through March. The New York Times.

The Fed’s mandate is essentially two things: control inflation and to promote full employment. The purpose of curbing inflation is to keep the prices of goods and services relatively stable, which it primarily does by manipulating interest rates for bank lending. During times of higher inflation, the Fed is expected to raise rates in order to make money more expensive and cool demand, thus preventing higher pricing power in the economy. The opposite would be true in a recessionary/deflationary event. In the current situation, 40-year high inflationary pressures are leading markets to price one of the most aggressive Fed rate hike regimes in decades, with futures markets pricing in three 50 bps (0.5%) moves over the next three Fed meetings (see chart below). This would be the most aggressive Fed action since 1994.

Source: Authers, J. (March 29, 2022). Not All Yield Curve Inversions Are Fatal. Bloomberg.

All it will take to derail these rate hike expectations, thereby creating a more favorable bond performance environment, is for inflation data to show signs of peaking and reversion towards the Fed’s targeted 2% inflation level. This would remove the upward pressure on yields that has been negative for bonds in 2022. A peak in both the broader headline CPI (consumer price index) number and more concentrated core PCE (personal consumption expenditures, excludes Energy and food unlike CPI) metric is being forecasted by the economist team at Goldman Sachs, though it is worth noting that inflation levels have already remained elevated longer than expected. When it does peak, that should give the Fed some ability to temper future rate hike expectations, which in turn should result in a more favorable bond environment. Bond markets will likely remain challenging while inflation readings remain high.

Source: US Equity Market Update. (April 2022). Goldman Sachs Global Investment Research.

Remaining Disciplined Amidst Uncertainty

High inflationary pressures persisting longer than expected coupled with the Federal Reserve embarking on an aggressive hiking schedule do not remove the dangers to stocks from high valuations and declining fiscal and monetary economic support that your CWM team has been highlighting in our recent articles and Thirdly events. The best response when nothing seems to be working is to remain disciplined and seek opportunity where it can be reasonably found, which means resisting the human fight or flight response to irrationally “do something”.

The overall bond sell off has created opportunities in the safer end of the investment pool, which has allowed your CWM investment team to methodically reposition some assets to take advantage of higher yields (income paid to the investment portfolio) without significantly increasing portfolio risk. This increases portfolio income expectations for the remainder of the year and should help replace some of the losses in the first quarter. Changes thus far this year are providing an almost full extra percentage point of income for the typical CWM portfolio versus where we were positioned at the beginning of the year and your CWM team will continue to look for opportunity to increase income levels without taking on significant additional risk.

All clients utilizing CWM Risk-Adjusted model clients should keep in mind that since 1926, there has not been a single 4-year rolling period where bonds have lost value. This includes periods that were deflationary, inflationary, stagflationary, Fed rate hikes, Fed rate cuts, quantitative easing timeframes, quantitative tightening timeframes, etc. The point being that though the present state of the markets has been uncomfortable, bond and similar type assets likely to recover over the longer term.

Source: Student of the Market. (April 2021). Student of the Market. BlackRock.

Like with other investment categories, the best time to buy an asset is frequently after it has taken a beating. In more recent timeframes, since 1976, sharp bond market drawdowns are fully recovered in 9-months or less, so the 4-year timeframe shown above is considered more of a worst-case scenario. In an ideal world, the stock market would provide a risk-taking opportunity well before that 4-year mark arrived.

Source: Bilello, C. (April 12, 2022). 7-Chart Tuesday and Markets Webinar Tomorrow. Compound Advisors.

A famous investing axiom “is nothing change sentiment like changes in price,” meaning that investors tend to love or hate something purely on whether it has recently risen or fallen in value. In the current case, bonds having a rough year has resulted in a high level (in the top 25 examples on record) of fund outflows from various related investment products as investors panic out of their bond positions. This actually creates fertile ground for a rally in this particular asset class. Since 1993, similar levels of fund outflows have resulted in a average gain of 8% in the next year. Large outflows are an indicator of potential future positive bond market outcomes.

Source: Student of the Market. (April 14, 2022). Blackrock.

Additionally, the current bond experience is the third worst two-year sell off in history since 1926. The other five negative periods show below were all followed by positive bond movement (average 10.66%, median 9.1%, low 3.1%) over the next two-years. The takeaway from this and the above is that while 2022 has thus far been challenging, the stage is being set for a period of bond price positivity if history is any guide and we believe investors should remain disciplined in the face of short-term disappointment.

Source: Student of the Market. (April 14, 2022). Blackrock.

There is no guarantee the future perfectly mirrors the past, which is always the great challenge for investor psyches when nothing seems to be working as expected. Your CWM team will maintain our disciplines as that, even with imperfect information about future potential market outcomes, has a far greater chance of future success than fear-based decisions predicated on near-term negative market activity.

If you are interested in a deeper dive into the current market data, please visit the News section of our website or contact us to schedule an appointment with your CWM advisor.

*Past performance is no guarantee of future results.