THE prospect of rapid United States monetary re-tightening to cool the hottest inflation in 40 years has unnerved both equities and bonds so far this year – but history suggests it’s unlikely that both end 2022 in the red.
Research going back to 1926 shows that, depending on what bond data you use, the S&P 500 and Treasuries have posted negative annual returns only a handful of times, even though both have often declined in tandem in the month of January.
This January was brutal for markets.
The S&P 500 total returns index fell more than 5% and the Bank of America US Treasuries index fell almost 2%.
These downdrafts have continued in February.
This was the 16th January in almost a century in which both fell, according to strategists at Truist IAG.
They use a 65%-35% split between intermediate – and long-term bonds as a proxy for 10-year Treasuries because some historical data is patchy.
Their research shows, however, that both asset classes delivered negative annual returns only twice in that time: 1931 and 1969.
Using a different proxy for government bonds, research by New York University (NYU) shows that S&P 500 and Treasuries returns have declined in four years: these two, plus 1941 and 2018.
Even then, at minus 0.02%, Treasuries were essentially flat in 2018.
Keith Lerner, co-chief investment officer at Truist, recognises that the weak start to the year for stocks and bonds in the face of high inflation and frenzied Federal Reserve (Fed) fears increases the probability that both asset classes end the year lower.
But the economy is on track to expand by more than 3% and earnings growth is still predicted to be a fairly resilient 11%, according to the latest Reuters estimates.
Against that backdrop, stocks may have room to recover yet.
“We view it as more likely that bonds are down but stocks are positive for the full year,” Lerner said.
That remains the general consensus on Wall Street, but it may depend on how much Fed tightening is priced in.
Right now, it is around 150 basis points, so stocks will likely get a lift if some of that comes off.
Another cause for cautious optimism may be 1994.
That was the last time the Fed undertook a sustained tightening cycle, which included interest rate increases of 50 and 75 basis points.
Treasuries lost 8% that year, according to NYU, which was the biggest annual fall up to that point since at least 1928.
But the S&P 500’s maximum drawdown that year was less than 10%, and the index ended up delivering total annual returns of 1.33%.
Key metrics of the US financial landscape – government debt levels, the Fed’s balance sheet, and markets’ interest rate sensitivity – are vastly different now from 1994.
Bill Callahan, investment strategist at Schroders, admits that the traditional portfolio split of 60% equities and 40% bonds will find it difficult to generate anything like the returns that have been clocked up in recent years. Equity and fixed income valuations at the start of this year were very high.
But investors’ skittishness in recent weeks may have reached extreme levels.
Look at the two-year yield’s reaction to the January inflation data and hawkish comments from St. Louis Fed president James Bullard on Feb 10: it jumped 24 basis points, its biggest one-day rise since 2009.
“These are rare events which you should almost lean into.
Markets are way ahead of where the Fed will get to. The Fed will choose to let inflation run higher rather than let asset prices melt down and lead to financial instability,” he said.
So far this year the S&P 500’s total returns are down 8% and Treasuries returns are down 3.5%. There is a long way to go of course, but annual losses of that scale would be the largest since 2008 and 1994, respectively.
Investors will need no reminding that these were historically bad years for their respective markets. — Reuters
Jamie McGeever is a columnist for Reuters. The views expressed here are the writer’s own.