06.22.22: Over the years, bonds and stocks have played complementary roles in portfolio management, the foundation of which is built on diversification. Fixed-income securities tended to the slow, steady and boring quadrant of the portfolio pie chart. While equities thrive on growth, high-quality bonds, like Treasuries, tend to prefer stable, predictable growth, and shine in slowdowns. The S&P 500 declined in eight calendar years between 1976 and 2021; in each of those years, the bond market gained ground. The exception to this performance track record was 2022. Year to date, a portfolio comprising 60 per cent S&P 500 and 40 per cent Barclays Aggregate Bond Index has lost 18 per cent. That’s because both stocks and bonds have lost ground this year, a rare occurrence. In terms of calendar-year return, 2022 represents the second-worst showing for the 60/40 portfolio – besting only 2008 – and the worst start to a year since 1976. Now that the Fed has changed course, how should investors view bonds as a portfolio component?
Since the early 1980s, a secular decline in yields has provided a tailwind to both stocks and bonds, since the 10-year Treasury yield is a critical component of equity market valuation. Because returns for stocks and bond historically have been uncorrelated, they have been effective portfolio complements as both asset classes rarely decline in unison. But lately, however, they have. That’s because yields, which declined to less than one percent, got too low and were vulnerable to revaluation when the Fed reversed policy.
Years of monetary largesse, including $9 trillion of Federal Reserve bond buying, left bond yields well below their fair value. Through the lens of stocks, bond yields traded as much as four percentage points below fair value in 2012, using the S&P 500 earnings yield as a proxy for the 10-year BBB bond yield. Between 2014 and 2021, that figure sank to two percentage points.
Now that the yield on 10-year Treasury notes is two percentage points higher this year, intermediate and longer-term Treasuries are closer to fair value and better positioned to once again offer a portfolio offset to equities. This would be particularly true in a “hard landing” scenario, in which persistent inflation prompts monetary authorities to ratchet overnight rates substantially higher than planned. Treasury yields are currently discounting the Fed’s anticipated monetary tightening program. At just over 3 per cent, the 2-year Treasury yield is discounting the peak in the overnight rate. Ten-year yields, meanwhile, at 3.2 per cent, reflect the tension between shorter-term rates and longer-term rates. We believe longer-term rates would fall if the Fed were forced to raise overnight rate higher than 3.5 per cent.
On a longer-term view, our economic trajectory is relatively low. That’s because our nation’s working-age population, a critical component of potential GDP growth, is shrinking for the first time in our history. That leaves only productivity as our primary growth catalyst. Unless we open our economy to a population of able-bodied immigrants, long-term GDP would likely trend toward two per cent at best, keeping a lid on intermediate and long-term interest rates.
Historically, the 10-year Treasury yield has been a useful predictor of the benchmark note’s subsequent 10-year performance. In an environment in which US economic growth will struggle to keep its head above 2 per cent, a 3+ per cent yield could indeed be a valuable offset to equities.