April: In Like a Lion
Not since March of 2020, during the early panic associated with the COVID-19 pandemic, has the stock market suffered such a bad month. The S&P500 was down 8.72% in April. The Barclays Aggregate Bond Index was down 3.78%.
Through the market close on Friday April 29th, the S&P500 is down 12.94% for the year. There are many reasons for this. COVID is still an issue for the market, particularly in China. Additional important factors include an aggressive US Federal Reserve, inflation, Russia’s invasion of Ukraine and slowing growth throughout the global economy. Equity market returns are only half the story. The Barclays Aggregate Bond Index is down 9.42% for the year over the same period. This is highly unusual. The normal stock/ bond relationship is such that when equity markets are down, the bond market is usually up. A confluence of events has changed this dynamic such that conservative clients are now experiencing volatility similar to our most aggressive clients.
PIM Portfolios
We adjusted portfolios in January and February, anticipating the possibility of a more challenging market environment. For accounts in custody at Charles Schwab & Co., we sold the riskiest asset classes, (international small-cap and emerging markets), increasing our cash allocation. Remaining investments are performing very well relative to their benchmarks.
Of the 12 investments currently present in Schwab accounts, four are in the top decile of performance relative to their Morningstar category peer group. Seven are in the top quartile. Nine are in the top half. Three of 12 are in the bottom half relative to peer group. Of these three, one is outperforming its benchmark. The remaining two are within a percentage point of their benchmarks. In total, 10 of 12 investments in Schwab portfolios are outperforming their respective benchmarks. The remaining two are within one percent. For TIAA and Fidelity accounts, where investment options are limited, we reduced equity allocations in January in an effort to lower risk.
In aggregate, PIM portfolios are outperforming our internal benchmark models across the board. These relative performance statistics are fluid and change daily with market movements. We understand that relative performance doesn’t pay the bills. Absolute performance does, and all our models are negative for the year. Most PIM employees have their personal retirement and/ or investment accounts invested in PIM’s investment models, so we are experiencing the same thing that you are.
The natural question to ask is when absolute performance will be positive. The short answer is that the bond market needs to heal before the equity market can stabilize. The long answer follows.
The Bond Market
The bond market might be the least interesting and least understood investment market. Yet, the importance of the bond market to global economic stability far supersedes that of the equity markets.
Bonds and bank loans are the primary sources of funding for corporations. US Treasury bonds set the benchmark lending rate for corporate debt and other rates throughout much of the world. Whether you’re a US firm building a factory, a family buying a home, or a farmer selling your crop to the export market in Asia, US Treasury bond yields will have an impact on your cost/ benefit calculus.
Bond Pricing
One of the most confusing things about bonds is that they are spoken about in terms of yield, rather than price. For example, you might read that the yield on the 10-year US Treasury bond has increased. Intuitively, you might think, this is good. Investors in this bond will now earn a higher interest rate than before. That view is correct but only part of the story. To achieve this higher yield on a percent basis, the underlying value of an existing bond needs to have decreased.
Bond yields and bond prices have an inverse relationship. Bond interest (the coupon rate assigned to the bond at original issue) is fixed. The day-to-day value of a bond is variable. When high demand causes the price of a bond to go up, the fixed interest rate equals a lower current yield.
When investors are selling bonds in mass, bond prices go down and yields go up. If you see that the yield on the 10-year US Treasury bond has increased, what it really means is that investors are selling those bonds, possibly at a loss, driving the price down and increasing the yield.
This is what has happened so far this year. The Barclays Aggregate Bond Market is down 9.42% through the end of April. This means that investors have been strong sellers of bonds so far this year.
The Recent Past
The pandemic saw interest rates collapse to all-time lows, as buyers vacated the equity markets in favor of the relative safety of bonds – which drove bond prices up and yields down. During April of 2020, the US 10-year Treasury was yielding 0.53%. The yield for that same bond today is 2.9%, which means that investors have sold bonds and driven yields up. A change in yield that large reflects a decline of as much as 22% in the price of pandemic-era bond issues. This dynamic is not unique to the US market. German 10-year Bunds, known for being remarkably stable and low-yielding, have moved from -0.7% during the worst of the pandemic to roughly 1% currently. The story is similar across the developed and developing world.
The Fed has signaled its intent to increase the cost of money substantially over the coming year to slow economic activity and inflation. When rates increase enough, less profitable activities (building a factory, expanding a business, or stocking up on inventory) are curtailed. This results in less growth and lower inflationary pressures. Higher rates also feed through to consumer areas such as mortgages, car loans and general credit. The goal of the Fed today is to raise rates to a point where businesses and consumers decide to slow down their financial activities because the cost of money is too high to justify the expense.
The surprising aspect of this plan is how widely the market has shifted its expectations over the course of the year. 2022 began with an expectation of short-term rates (overnight rate, the only rate the Fed actually controls) moving from 0% to 0.75% by the end of the year. Inflation data and changing Fed posture in early January moved that year-end expectation to 1.75%. The war in Ukraine initially changed the figure to 1%. Subsequently, increased food and energy costs brought the expectation to 2.75%. That’s a historic level of volatility for a market that sets the cost of borrowing for a majority of the globe’s economic output. Volatility of interest rate expectations and the US Treasury market do not peacefully coexist. As a result of the confusion surrounding the path of future rates, investors have shed their bond exposure resulting in higher yields and lower prices.
The Extraordinary Monetary Policy Challenge
The Fed’s policy goal is to slow the economy to the perfect point where the supply of goods and services matches demand, bringing inflation rates to an acceptable level without tipping the US into a recession. This outcome is referred to as a “soft landing.” It is an exceptional challenge because interest rate policy works with a long and variable lag. Nobody knows, with foresight, the exact interest rate that balances supply and demand in the economy (known as the neutral rate, or r*). The challenge is especially fraught today due to the war in Ukraine and China’s zero-covid policy, amplifying the cost of basic goods (food and energy) and more discretionary consumer items imported from China.
The neutral rate of interest, the rate that is neither oppressive, nor unnaturally supportive of the economy, is estimated to be anywhere between 1% and 2.4%. The Fed believes the rate to be closer to 2.4%. Private sector economists, and a minority of Fed researchers, believe the rate is closer to 1%. With a 0.50% rate increase expected at each of the next two Fed meetings, it is possible that short-term interest rates will be high enough to slow the economy by June. The uncertainty around the neutral rate explains why the equity and bond markets are experiencing so much volatility. If you believe the neutral rate to be 1%, then any movement above that level will increase the odds of recession.
The rate of inflation is expected to moderate during the second half of the year, simply because price increases will be relative to the higher base rate of the year prior, and not the pandemic era lows of 2020. This does not mean prices will fall. Inflation is the rate of change in prices, not the level of prices. Lower rates of inflation may tempt the Fed to take a slower pace on their journey to higher rates than is currently estimated. Data can be found to support both a high and low inflation outlook, which again points to elevated volatility for inflation sensitive bonds.
The Big Picture
Bonds, especially the core bonds that we use in portfolios, are expected to provide ballast to the portfolio during times of equity market stress. This year they have done the opposite. Our bond allocation is capturing roughly ½ of the downside of the aggregate bond market, but absolute performance is still negative.
It may be useful to step back and consider the bond market over a much longer period, to see the forest, so to speak. Interest rates in the US have been in a structural decline since the early 1980s. This is an appropriate time to pause and consider our explanation of the inverse relationship between yields and bond prices. If interest rates have been in decline for 40 years, that means the bond prices have been on the rise for 40 years. This is true and is referred to as the secular bull market in bonds (secular meaning long-term, in this context).
The reasons for this long-term decline in rates are a growing level of debt, declining growth rates, aging populations, high wealth inequality and the globally dominant nature of US Treasuries as a store of value for foreign investors. These contributing factors have been growing in prominence over the past several decades.
Of principal importance is the level of debt in the financial system, which remains near all-time highs at 350% of GDP. Although consumers are financially healthy, corporate America and the US Government are mired in debt. As interest rates rise, so does the cost of rolling forward existing debt. Economists refer to this as the “debt trap”, where strong growth results in higher interest rates over the short term, which leads to a greater percentage of national income going to lenders in the form of interest payments, instead of remaining in the economy to support further growth. This siphoning of cash flow short-circuits the business cycle and leads to even more debt, slower growth and lower rates over the longer term. This debt scenario has been building over the past forty years and is clearly illustrated by the downward trajectory of the yield of the 10-year Treasury and the upwards trajectory of debt levels relative to the US economy.
Inflation, Equity Sectors and Wages
Three percent yield on the 10-year Treasury may be as high as the economy can handle. Even in light of hawkish Fed rhetoric, market-based forecasts have stalled at 3%. 
The market is sensing reduced demand for consumer goods. The stock prices of discretionary areas of the economy, as shown in the chart, are a substantial distance from their peaks. Many of these areas benefited from stay-at-home public health measures, such as home furnishings, consumer electronics and appliances. This suggests a return to normal levels of consumer spending and less inflationary pressures. Less inflationary pressures suggests lower bond yields and higher bond prices.
The most important aspect of the interest rate analysis is the state of the labor market. The Fed is desperate to avoid a wage price spiral, where increased wage pressures cause firms to increase prices for their finished goods. While prices of goods can adjust up or down to meet demand, wages tend to only move up. Persistent wage growth can create a self-fulfilling cycle of higher and higher levels of inflation.
As rosy as the overall employment data looks, the supporting data may suggest the beginning of a cooling off period. The Atlanta Fed’s wage growth data has peaked, as have job openings in the JOLTS data. Small business hiring expectations have been ebbing since October of 2021, according to survey data. Employee wage growth expectations have also begun to decline. These are small changes at the margin, but important indicators worth noting.
If the labor market is beginning to soften, the first place that shift would be apparent would be in retail sales and home sales. Both are weakening. Retail sales have declined on a real (inflation adjusted) basis for five of the past six months. Retail store inventories are at an all-time high (inflation adjusted) according to Federal Reserve data, suggesting lagging demand relative to expectations. Home sales (volume, not price) have declined for eight months in a row. Overall sales numbers are surprisingly strong in light of 5% mortgage rates, but the trend is clearly down. Negative GDP growth for the first quarter of the year is evidence of a slowing economy. Weakening economic data is great news for the bond market.
As unpopular as bonds have been for the past few years, they still play an important role in any portfolio: stability and income. The market has been through an exceptional period of rapidly changing expectations and, frankly, a Fed that is playing catch-up. It does appear that the long-running structural trends that have supported the bond market for forty years are alive and beginning to reassert themselves. The upside to the general decline in the price of bonds over the past several months is that the bond market can again provide income. Yields on some aspects of the bond market, that we incorporate into portfolios, are now above 5%.
Conclusion
At this point we must sound like a broken record when we say the Fed is the number one risk to the markets. That has been our viewpoint for the past five months, and nothing has changed this view. As we move through this period of heighten volatility it is important to remember that the economy is self-correcting; it seeks equilibrium. What can appear to be a very dire situation one day can, with a smattering of unexpected, positive data points or a quip from the right person, quickly become a rosy outlook. The Fed has conditioned the market for much higher interest rates. If the economy cools on its own to a sufficient degree, bonds may stage a meaningful recovery.
Another, perhaps easier to understand, way of looking at this is that the COVID-19 pandemic shocked global capital markets. Quick and substantial monetary policy and economic stimulus measures were enacted that provided not just stability, but strong support for equity markets and encouraged greater consumer demand. The downside to these measures has been inflation. Inflation may moderate on its own, as consumers choose to defer spending and as supply chains slowly come back online. Or, it may require active intervention, as the Fed intends. Either way, we are experiencing a necessary transition back to an economy that operates efficiently and naturally on its own. Such transitions can be painful. But taking the long view, they are temporary.