Market Review

Over the last forty years or so we have been in an era of declining bond yields. One where in periods of market stress, fixed income allocations have served to deliver a positive return and offered some protection from equity market losses. 2022 has proved different with both fixed income and equities suffering from falls of equal severity as markets get shaken by the re-pricing of central bank interest rate expectations, which has seen equity valuations deflate at the same time as fixed income yields rise.

So, why hasn’t fixed income protected?

Fixed income has done a particularly poor job of offsetting equity market volatility so far in 2022. This is chiefly because we are living in a time of significant inflation, which hasn’t been a feature of the investment landscape for decades. Markets are currently facing both an inflation and interest rate shock at the same time, which is driving market volatility and with it an increasingly positive correlation between fixed income and equity returns (where they both fall together). So, is the current relationship unusual? Using data sourced from Vanguard who looked at previous decades of high inflation and compared it to the period since the start of the millennium, they found that in decades of higher inflation, there was a greater positive correlation between bonds and equities than in periods of low growth and low inflation, which has typified the world since the 2000’s.

Whilst we are in this period of inflation shock we can expect the weakness of both equities and fixed income to continue. The questions that then follow are:

  1. How long will inflation remain so elevated?
  2. What comes next?
  3. (and) Is it worth holding fixed income?
  1. How long will inflation remain so elevated? The expectation is for inflation in the US to begin to taper towards the end of this year and, for what it’s worth, the Bank of England is anticipating inflation falling early next year, albeit with energy volatility and sterling weakness, there’s potential for this to be pushed back even further. If inflation falls sharply through 2023, the clamour by central banks to push interest rates higher will begin to abate and for this current rate and inflation shock to pass.
  2. What comes next? With interest rates rising sharply, consumer confidence plummeting and sky-high prices on our energy bills and our shopping baskets, recession risks are rising, and we are moving towards a growth slowdown. The faster interest rates rise, the greater likelihood that we are tipped into recession and the shorter the period will be before central banks need to reverse course and begin to bring interest rates back down. In this environment, we are likely to see a re-establishment of the negative correlation between equities and fixed income. There are some nascent signs that bond yields are reacting to this as we go to press, but it remains too early to be definitive in this. Whilst equities could remain under pressure as the corporate earnings environment becomes tougher, fixed income markets are likely to benefit from price rises as yields drop in response to a return to the predominant market dynamic of the last 15 years, namely one of lowering yields driven by supportive central bank policy.
  3. Is it worth holding fixed income? In short, yes but with caveats. Yields across the fixed income world have not been this attractive for years. With investment grade bond funds yielding around 3% and high yield funds offering around 5% this offers an attractive income starting point for investors. It still feels too early to accept increased interest rate risk in portfolios but should we see clearer evidence that bond yields are peaking, then beginning to look to benefit from rising prices as yields fall with remain at the forefront of our minds in the coming quarters.

I mentioned caveats and in portfolios, where appropriate, we still retain significant holdings in conservative, multi-asset funds such as Troy Trojan and Ruffer Diversified Return. Over the long-term they have been able to limit downside risks and deliver positive returns and we see them as essential parts of what would have formed the fixed income allocation in a ‘traditional’ balanced risk 60/40 stock/ bond portfolio. This is likely to continue.

In summary, investors have been hurt by the combined sell-off in both equity and fixed income markets. This is unlikely to continue as inflation eventually rolls over and interest rate rises push economies towards either a growth slowdown or an out and out recession. At this point, the negative correlation benefits of fixed income are likely to be re-established as bond yields fall and central banks turn from hawkish to becoming more supportive in their efforts to keep their economies growing. The decline in prices that have taken place through this year has opened up a more attractive fixed income world, particularly for income investors. As we move from the inflation and rates shock environment to a growth slowdown, there could also be an additional tailwind for fixed income holders of a return to a falling yield environment (with bond price rises).

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