🔒 Markets are topsy-turvy, and there’s worse: It’s hard to cushion your portfolio – with insight from The Wall Street Journal

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Markets Are Topsy-Turvy, and There’s Worse: It’s Hard to Cushion Your Portfolio

Stocks and bonds are going down together—in a way they haven’t for years

By James Mackintosh

Good news is bad news, and on Friday it was very good, and very bad. The monthly payrolls report showed a superstrong labor market, with more jobs created than expected and unemployment matching a 53-year low. Stocks dropped, as did bond prices, with bond yields up. Such is the world of high inflation—and it is creating serious problems for those trying to cushion their portfolios against severe loss.

The basic pattern of markets for the past two decades has been reversed. Investors grew used to it, but it no longer works: Strong economic data meant better profits, so were good for stocks, but also meant a little more inflation, so were bad for bonds, pushing up yields. For 20 years there was a strong tendency for stocks to rise on days when bond yields rose, and vice versa.

Now the stock market is also focused on inflation and the Federal Reserve’s plans, so good economic data are bad for stocks, while still being bad for bonds (higher yields).

Making it even worse is that the past two decades (and more) had an underlying trend of lower bond yields, meaning holding bonds both protected a portfolio on bad days—because yields would fall and prices would rise as stock prices fell—and made money over the long term. Investors got free insurance. Now the win-win has turned into lose-lose, as the pattern reverses and bond yields rise.

The standard low-risk portfolio of 60% stocks, 40% bonds has been hurt badly as a result. U.S. stocks have lost 21% and 10-year bonds 17% this year, both with income reinvested—which if sustained would be the worst calendar-year result for a 60/40 portfolio in data back to 1980. Jim Reid, a Deutsche Bank strategist, calculates that after inflation an equal-weighted stock-bond strategy has had its worst year since 1974—and in Germany the worst since the creation of the Deutsche mark in 1948.

A formal measure of the link between U.S. stocks and bond yields, the correlation, shows they have moved in opposite directions in the past 200 trading days more strongly than at any time since early 2007, just before the global financial crisis. The link is nowhere near as strong as in the 1970s, 1980s and 1990s. But if inflationary pressures become a permanent feature, stocks and bonds could end up trading like they did back then, making it far more expensive for investors to protect their holdings.

This isn’t about some irrational behavior by investors. Higher interest rates were always bad for stocks, but back when the stock-bond link was the other way around, the prospect of a better economy also brought the prospect of profit growth more than offsetting the damage from higher rates. For Treasurys, a better economy and the resulting higher rates are almost always just bad.

The problem for stocks comes from the economy’s being at full capacity. Instead of bringing higher real growth and profits, more strength in an economy with little to no slack merely brings inflation. The price of stuff, and wages, goes up, which is hard for companies to manage. Meanwhile, the extra inflation means higher rates, which are bad.

If this lasts, investors will need to get used to bigger swings in portfolios, less cushion from bonds and more of a search for assets that offer diversification.

In the short term it might not last, although this shouldn’t be reassuring for shareholders.

“It will move quite quickly from bad is good to bad is bad [for stocks] because people will say ‘Oh no, there’s a recession,’” says Ben Funnell, who runs asset allocation for CCLA Investment Management in London.

On the plus side, a recession should bring down inflation faster and lower bond yields, meaning bonds should gain as stocks are hit again. The rise in yields means there is now more room for yields to drop back, so bonds should once again provide decent protection (unlike German bonds in 2020, where yields were already so low that prices barely rose despite the shutdown of the economy).

In the long term, the debate remains finely balanced between a return to the “new normal” of low rates that ruled from 2010 onward, when stocks were very strongly correlated to bond yields, and a new world of higher inflationary pressures.

I expect continued upward pressure on inflation, meaning higher rates are required to meet the Fed’s 2% target and the stock-bond link will be more like the 1970s and 1980s. Workers have gained political power, governments are more willing to run big deficits, deglobalization and outright protectionism have reduced cross-border trade and efficiency, and there won’t be a repeat of the shock of hundreds of millions of Chinese workers suddenly competing in the world economy.

Against that, technology continues to promise cheaper stuff. The post-2000 equity-bond relationship might just reassert itself due to investor muscle memory, too. Back in the 1990s, inflationary pressures had abated, yet it took until late in the decade before there was a sustained shift in the correlation.

For now, investors are in a bind. If that lasts, we will have to get used to a world where we once again accept there’s a cost to cushion a portfolio against loss in the bad times.

Write to James Mackintosh at [email protected]