The conventional wisdom is that bond prices go up when stock prices go down. This hasn’t been the case in 2018, as stocks have posted negative returns alongside bonds.
It’s no wonder, then, that we’re now getting asked even more frequently whether bonds are still a good hedge to stocks. Our answer to the hedging question: yes, but with a caveat, as we write in our new Fixed income strategy piece Summer of ‘69.
Bonds offer some balance for portfolios with equity exposure. For much of the past 30 years–the bond bull market–bonds have played twin roles for investors: diversification and returns. Bonds generated strong returns in their own right, while providing a critical offset to equity risks in times of financial shocks or economic recessions.
History provides a guide
It is rare to see negative returns in both stocks and bonds in the same year. Of the 24 years with negative equity returns since 1929, U.S. 10-year Treasuries generated positive returns in all but three. See the chart Bonds hedge growth, not inflation risks below (the chart uses S&P 500 Index data back to 1957 and data for an earlier iteration of the index prior to that).
Two of the three historical exceptions were unique events: Among the causes in 1931 were the collapse of Austrian bank Credit-Anstalt and the currency crisis that forced Britain to abandon the gold standard; in 1941 it was the U.S. entry into World War II.
The 1969-70 episode stands out: excessively loose monetary policy coupled with late-cycle fiscal stimulus led to a decade of de-anchored inflation expectations. As growth faltered in 1969, bonds suffered losses even as stocks stumbled. And in the 1970s, bond prices fell in several years of negative equity returns (though high starting yields kept total returns positive). A Federal Reserve trying to quell runaway inflation triggered the equity selloff during this episode.
For most of the new millennium the correlation between bond and equity returns has been negative. Yet the relationship has become more unstable in both the U.S. and the Euro-zone since the end of the global financial crisis. Periodic reversals in the relationship include the “taper tantrum” of 2013, when both equities and bonds sold off in response to Federal Reserve hints about a tapering of its bond purchases. Other examples are the German bond yield spike in 2015 and the more recent equity market sell-off in February. These periodic market “tantrums” show that when concerns beyond growth–such as inflation–dominate, stocks and bonds can both fall at the same time.
The overall lesson
Bonds help cushion against growth risks but not inflation risks. It’s shocks to growth that make the negative relationship hold. Bonds tend to perform well in recessions as they are deflationary, with falling activity and prices (or expectations thereof). But history shows bonds can fail to offset equity losses in periods where inflation fears rise.
During the most recent relationship-reversal episodes, a traditional bond allocation (such as to the Bloomberg Barclays U.S. Aggregate Bond Index, for instance) would have exacerbated portfolio risks, rather than provide a buffer. This is a result of the ultra-low interest rate and quantitative easing (QE) policies that have spread low interest rates across the curve. With interest rates finally on an expected path toward normalization, at least in the U.S., bonds may be less reliable as ballast.
Today inflationary pressures are far more subdued. What will be the shock that derails the current cycle?
A trade war tightening financial conditions and hitting growth. We believe bonds would cushion portfolios in such a scenario. We see no imminent signs of recession, but how any recession manifests matters.
Short-duration, floating rate, inflation-linked and credit exposures can help offset inflation risk. And we see long duration exposures helping cushion portfolios in a financial shock scenario that hits growth. Read more bond market insights in our Fixed income strategy.