Stocks & Bonds – In this article you’ll find:

• Stocks & Bonds – 2022 has been an anomaly, is it time for bond?
• Keep high your attention with Portfolio volatility, could be crucial for the long term.
• Stocks & Bonds – What can happen now?

Here you can find other articles:

1. Q4-22 is arrived. What We Could Expect in 2023?
2. We Need To Produce More Food
3. Crush Economic Growth or Live With Inflation? Is The Fed Ready?

ENJOY THE ARTICLE

Stocks and bonds are rarely down at the same time

Introduction

Stocks and bonds are down and is clear that we are in an anomaly year, so I agree with Charles Schwab when say that is very unlikely to see the same thing the next year.

High inflation could result in more rate hikes than initially expected. The Fed does not want to risk inflation becoming entrenched.

With an upper bound of 4%, the Fed’s policy rate should now be considered restrictive, and it should be followed by a period of below-trend economic growth.

There are plenty of reasons for the Fed to slow down the pace of hikes, like the recent inversion of the Treasury yield curve. When long-term yields drop below short-term yields, a recession tends to follow.

In this episode let’s see how bond markets are witnessing a brutal year and what we could expect forward looking.

Let’s repeat how portfolio volatility could impact drastically you return in the long run.

And finally let’s see why this tightening cycle by the FED is very abnormal fast and what could happen right now.

Historically, bonds have provided a buffer when stocks fell. Since 1976, there have only been thirteen 12-month periods, or 2.4% of the time, where both stock and bond returns were negative.

Charles Schwab lets us to know that here are a few things to highlight in the above chart.

First, usually when stocks have fallen, bonds have usually posted positive returns, as evidenced by the number of green bars. Second, this past year has been an exception.

The 12 months ending October 31, 2022, have been among the worst periods for equities and for bonds.

By contrast, for the 12 months ending in February 2009, equities were down more than 44% but bonds delivered a positive 2% total return.

Limit the upside for longer-term bond yields

Returns have been historically weak this year for two primary reasons – starting yields were very low and the Federal Reserve’s pace of rate hikes has been very rapid.

Since March the Fed has increased the federal funds target rate five times, pushing it up from near zero to a range of 3% to 3.25%.

It has been the fastest and most aggressive pace of tightening going back to the early 1980s.

However, we believe that going forward the pace of rate hikes will slow and ultimately stop, which should limit the upside for longer-term bond yields (which move inversely to bond prices).

Adjusting portfolios

One of the benefits of high-quality bonds is that historically, their returns have not fluctuated as much as equities have.

This can help smooth diversified portfolio returns. For example, since 1976, the worst rolling 12-month total return for a portfolio of 30% bonds and 70% stocks was just over negative 30%.

For a portfolio with a higher allocation to bonds, 70% in this case, the return over that same period was negative 12%.

Stocks – I love numbers

Charles Schwab helps us with the above chart, which shows us the impact to a hypothetical $500,000 that’s distributing $20,000 per year adjusted for inflation for 30 years.

In each case, the portfolio experiences an annual return of 6% for all but one year. During the year it doesn’t earn 6%, it loses 20%.

In the “big drop initially” case the 20% drop comes in the first year the portfolio is taking distributions, whereas in the “big drop late” case the 20% drop comes in the last year.

The portfolio returns are the same, it’s just the timing that’s different (this is a concept also known as “sequence of returns” risk).

Summary of the example

In the case of the portfolio that experienced a 20% decline initially, it would have run out of money after 27 years of withdrawals assuming no other adjustments.

However, the portfolio that experienced the 20% decline late would have ended with just shy of $400,000 after 30 years of withdrawals – a substantially different outcome, solely due to the timing of returns.

This matter because a portfolio with a greater allocation to bonds historically has been less volatile and less likely to experience large drops.

Stocks – Important Consideration

• The Federal Reserve continued its aggressive pace of rate hikes, raising the federal funds target rate by 75 basis points – a move that was widely expected by markets, given that inflation is still running at multi-decade highs.
• Portfolio volatility matters for both risk capacity and risk tolerance. Risk tolerance is simply an investor’s emotional comfort with taking risk. In other words, how big of a drop in your portfolio will keep you up at night?

Time for bond?

It’s been a brutal year for fixed income, but that’s not a reason to avoid bonds going forward. This year has been an anomaly and is unlikely to repeat, in our view.

Going forward, returns should be better because starting yields are higher and it’s unlikely that rates will continue to rise like they have.

Charles Schwab suggests investors consider extending duration to take advantage of the move up in yields and stay up in credit quality by focusing mostly on higher-rated bonds.

What happens now?

Monetary policy typically acts with a lag. We’ve seen the impact of tighter policy in some areas of the market – like housing, where activity has slowed – but it has been slow to manifest in other areas.

This has been the fastest rate-hike cycle of the past four decades – a lot of tightening has already taken place and likely still needs to work its way through the economy.

The markets are pricing in a “peak” fed funds rate of more than 5%

While there have been hints of a potential slowing of rate hikes, this cycle is not over yet. Even with a potential reduction in the size of each hike, markets are expecting a “peak” fed funds rate of more than 5% in May 2023.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.

In doing so he shares with you the most interesting charts and comments.

Disclosure

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. 

This material has been prepared for informational purposes only. 

Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.