FIXED INCOME INSIGHTS

How I learned to stop worrying and love
the bond

Apr 12, 2019
By Jeffrey Rosenberg

Fixed income market highlights

  • Bonds have returned to offsetting economic (and equity) risk in investor portfolios and the outlook for dampening inflation played the critical role fueling the change.
  • The lack of inflation pressure enabled the Fed's dovish pivot, fueling rallies in global markets.
  • We see overstated fears in frequently asked questions surrounding leveraged loans and comparisons to pre-crisis subprime lending and CDO-type risks. Rather than systemic, we see the loan market holding the potential to exacerbate cyclical downturns, reflecting typical late credit cycle conditions.

Significant declines in global interest rates reflect a slowing global economy, and crucially a dovish pivot by the Fed across the first quarter culminating in the March FOMC meetings. At the end of March, the market priced in the probability of future Fed cuts, while speculation of what accommodation tools the ECB has left proliferated. Reflective of these concerns, the U.S. yield curve inverted and the German bund yield returned to negative territory.

Yet those bond market moves highlight a critical theme for investors in 2019: Bonds have returned to play their traditional role of offsetting economic (and equity) risk in investor portfolios. 

The summer of ’69 (what
we learned)

In contrast, the negative returns to both stocks and bonds throughout most of 2018 presented investors with a critical challenge as—rather than offsetting losses—bonds contributed to equity losses as higher interest rates accompanied expectations for Fed normalization. That led to the exceptional possibility of seeing only the fourth year in history (going back to 1929) where both stocks and bonds posted negative returns for the calendar year.

Both negative stock and bond returns are rare
Annual stock and bond returns (1929-2018)

Annual stock and bond returns (1929-2018)

Source: BlackRock calculations based on data from Bloomberg.

The chart highlights that this outcome is exceptionally rare. The 1931 currency crises under the gold standard and a British pound world reserve currency, and the 1941 entry into WWII led to both negative stock and bond returns. Outside of these unique historical events, 1969 stands out as the exception that proves the rule.

The recession of 1969-70 and the negative stock and bond returns of 1969 that proceeded it highlight the “overheating” source of recession. Entering the decade with low inflation, by mid-1966 inflation hit 2% and subsequently rose to just under 5% by the end of the decade. The Fed response was to raise short-term interest rates that pushed the economy into recession and caused negative stock returns. Along the way this pushed bond yields higher, resulting in negative bond returns as well.

What’s the key takeaway for investors? The key lesson: bonds hedge stocks during downturns when the source of the downturn is a growth shock, which typically leads to declining inflation expectations. But when stocks decline due to rising inflation concerns, bonds suffer as well, undermining their role as portfolio diversifiers.

In 2018: Inflation fears undermined bonds

At the beginning of last October, Fed Chair Jerome Powell’s description of policy rates as “far from neutral” suggested multiple future increases in rates. Then, the Fed acted to normalize out of fear over the possibility of future inflation. But this expectation undermined the ability and willingness of investors to hold bonds to offset risks in their stock portfolios. As a result, during Q4 2018, stock and bond return correlation increased as returns for both asset classes declined.

Stock and bond correlation trends negative in 2019 after rising in late 2018
Stock and bond correlation over time

Stock and bond correlation over time

Source: BlackRock calculations based on data from Bloomberg.

In 2019: A lack of inflation underwrote the “Powell Pivot”

The Fed’s pivot to dovishness in January changed the rate hike outlook, citing a lack of inflation for its rationale. That pivot freed up investors to reallocate to bonds as a portfolio hedge as expectations for future rate increases fell, restoring bonds role as portfolio diversifiers. Looking forward, the lack of broad based inflation despite tightening labor markets accelerating wage inflation represents a key dynamic. We expect broad based inflation to remain in check in 2019, yet the outlook for wage inflation remains less clear as signs of acceleration appear both in broad measures of wages as well as in survey based measures of wage expectations.

Today’s forces of globalization, demographics and technology, along with a possible improvement in productivity, have contributed to keeping these wage pressures on inflation in check. We view the Fed as on hold and willing to tolerate the rise in wage inflation as long as broad based inflation remains benign. For portfolio construction, that should return bonds to their traditional role as providing diversification benefits. However, as the lessons from 2018 and 1969 point out, inflation represents a key risk to those views and traditional portfolio construction strategies.

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Jeffrey Rosenberg
Jeffrey Rosenberg, CFA, Managing Director, is a senior portfolio manager leading our alpha-seeking long-only and factor efforts for Blackrock’s Systematic Fixed ...
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