Ever since the Federal Reserve embarked on aggressive tightening of monetary policy in March 2022, warnings of an impending recession have become prevalent. As an example, in June 2022, esteemed JP Morgan CEO Jamie Dimon warned of an “economic hurricane” ahead. At that time, the inflation rate was around 8.6% (as measured by the consumer price index) and interest rates across all bond maturities were rising quickly. To the surprise of many economists and market participants, a recession has not materialized to date. Instead, the broad economy has remained relatively stable, driven mainly by a strong service sector that has engendered a surprisingly robust labor market.
Prognosticating the timing and depth of recessions is likely a fool’s errand. And even if one can successfully portend the timing of a recession, that may not be sufficient in positioning one’s portfolio to mitigate the variegated investment risks. Why?
Looking back at the three previous U.S. recessions, each had markedly different causes and consequences, as well as dissimilar financial market responses. They were characterized by a global pandemic (2020), a housing and banking crisis (2008-2009), and the unwinding of a speculative internet and technology stock bubble (2000-2002). Therefore, should an economic slowdown occur in the United States, successful portfolio managers will require a unique playbook based on the nature of the current economic environment.
What was similar about each recession, however, was that they induced major selloffs in the broad U.S. stock market while bonds performed significantly better. Not only have bonds historically protected portfolios during past downturns, but fixed income securities now offer substantially higher yields than the previous 15 years. So why not go all-in on bonds?
The Long-Term Path of Inflation Remains Uncertain
The global economy continues to face persistent inflationary pressures that have been relatively absent since the early 1980s. At that time, inflation was running in the double digits and interest rates soared in response. (Note: The current overnight Fed Funds rate is now above 5% from near zero in early 2022). There were multiple causes for the decade-long inflationary economy of the 1970s and early 1980s. Rising budget deficits to help finance the Vietnam War, the decoupling of the U.S. dollar from the gold standard, and the 1973 Arab oil embargo were among the most prominent culprits. The best performing investments during that decade were more untraditional, including commodities (e.g., energy) and precious metals such as gold and silver.
Fast forward to the recent run-up in inflation, Federal Reserve Chairman Jay Powell finally conceded his inflation miscalculation at the Jackson Hole Symposium in 2022. He articulated his firm commitment to bringing the inflation rate down to 2% at seemingly any cost. Despite raising interest rates over five percentage points in just 16 months, inflation remains stubbornly above normal due to a strong labor market, pent-up demand for services, and a stronger-than-expected housing market. In recent months, there has been meaningful progress in lowering inflation, albeit remaining decidedly higher than the Fed’s stated target of 2%. Given the progress on the direction of the inflation rate, broad consensus holds that interest rates have perhaps peaked.
However, given the highly unusual crosscurrents in today’s economy, one should consider alternative scenarios. One such scenario is that inflation remains sticky and perhaps reaccelerates. In the 1970s, the path of inflation was non-linear. For example, CPI was 11.04% in 1974, 5.76% in 1976, and then rose to 11.35% in 1979. Today, we have numerous secular headwinds that can keep inflation at elevated levels. Examples include the continued labor market tightness, aggressive manufacturing reshoring policies, the lack of investment in energy and other strategic commodities, and the consensus that consumer spending will remain robust.
So, whether the economy enters a downturn or not, there are no assurances that the path of secular disinflation will continue unabated. Should we enter a recession, the Federal Reserve could resist implementing aggressive monetary stimulus that was a characteristic of prior recessions lest it drive inflation even higher. This could put a higher floor on bond yields and eliminate some of the benefits of owning bonds during an economic downturn.
The Cost of Missing Out
Investors with a longer time horizon or those without income requirements should carefully consider the opportunity cost of owning bonds. In purchasing a fixed rate asset, such as a bond, one is essentially foregoing the historically higher capital returns that have benefitted long-term equity investors. In a Nasdaq report titled “2022 Stock and Bond Returns in a 97-Year Perspective,” the author highlighted the vast outperformance of stocks over bonds in the long run. Bonds, as measured by the Vanguard Total Bond Index, returned an average of 5.7% annually from 1926-2022. In comparison, stocks, as measured by the S&P 500 index, returned 10.11% annually over the same period.
Considering the strong performance of the S&P 500 and Nasdaq 100 indices so far this year, one might question the outlook for future equity returns. But overall gains have been largely driven by a handful of large technology companies, particularly those which are deemed to have a competitive position in the emerging technology of artificial intelligence (AI). Meanwhile, the vast universe of stocks has seen substantially subdued performance on average. Therefore, it could easily be argued that those stocks and sectors that have been left behind offer investors the opportunity to generate healthy future returns.
Long-term investors should avoid regularly shifting allocation between asset classes based on economic gyrations and investor sentiment. This is especially important given the many undervalued equities, as well as the questionable efficacy of bonds as a risk mitigator. Rather, most investors should maintain a disciplined strategic asset allocation framework with periodic rebalancing to ensure one’s portfolio aligns with the investor’s objectives, risk tolerance and time horizon.
A Final Thought: Not All Bonds Are Created Equal
Many market participants get entangled in popular mainstream narratives around asset allocation (i.e., 60/40 portfolio allocation) without carefully considering the risk characteristics of the individual components of the asset classes. The disparate performance of short- and long-term Treasurys in 2022 was a great reminder that not all bonds are created equal.
While historically heavy losses in longer-term fixed income assets may now be in the rearview mirror, one needs to consider the vulnerability of less creditworthy bonds should we be on the cusp of an economic downturn. In a recent Federal Reserve note, the two authors cautioned that “the share of nonfinancial firms in financial distress has reached a level that is higher than during most previous tightening episodes since the 1970s.” Therefore, one’s bond portfolio should be more than a simple percentage allocation decision. I believe that successful bond investing in this uncertain environment will require a more nuanced examination of the specific risks of the many components of the bond market to ensure proper alignment with the investor’s risk profile.
The views presented are those of the authors and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. Any investment involves risk. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.
Joseph Caplan is Vice President, Investments, at Caplan Capital Management. In addition to the Jewish Link, he has written for Barron’s Advisor and other publications. He received his BA in economics from Rutgers University.
