The Changing Market Regime
A warm welcome and explanation on why you should care about bonds
Welcome to the first post of the Female Bond Fellowship’s Newsletter!
Let me give you a bit of background on why we’re creating this newsletter in the first place and what you can expect.
The purpose of this newsletter is to make fixed income more accessible. When I first got interested in fixed income, I found it hard to draw inference from the news.
This newsletter will be simple and easy to read. We will focus on three pillars:
Market news: here, we will analyse market news in simple language.
Deep dive: analysing research papers.
Spotlight: interviews with inspiring industry professionals
Given that this is the first newsletter, I think it would be apt to cover why you need to care about bonds, today.
When I studied finance in college, I couldn’t help but think that if the S&P 500 could give me returns of about 36% from 2011-19, why would I even consider PAYING for a fund that gives me any less.
I wasn’t wrong.
For the past 40 years or so, we’ve seen inflation steadily declining and as a result interest rates too. This bolstered equity returns because when interest rates are low, P/E ratios are high, and if P/E ratios are high, earnings are strong.
This regime experienced a paradigm shift in 2021.
In 2022, interest rates have been hiked at their fastest rate since past 40 years. Just look at the graph below!
2022: Fed Rates increased 18-fold from 25 bps to 450 bps
Source: Visual Capitalist, 2022
Looking at history, we notice similarities. In 1973, the Arab oil situation led the economy to sharply increase rates, and the inflation in 1980, combined with an oil shock, led ex-Fed Chair Volcker to increase rates. This time around, the invasion of Russia in Ukraine, political tensions in China, and the post Covid supply-led inflation, were followed by the fastest increase in rates since the Volcker era.
In Ray Dalio’s words, “the best way to anticipate the future is by studying the past. History repeats itself. By looking into past situations, we can try to guess what might happen in the coming years”. What we can learn from 1973 and 1980 is that stocks did take some time to recover, particularly after adjusting for inflation.
From the interest rate peak in January 1973, it took investors 13 long years until 1985 to get their money back from U.S. stocks (in real terms). In 1980, inflation was beaten and recovery was quicker, but it still took three years for investors who invested at the peak, to make whole.
Looking at what this means for us, academics Elroy Dimson, Paul Marsh and Mike Staunton calculated U.S. stocks delivered 5.9% a year after inflation since 1970. If stocks merely rack up an average performance, it will take three to four years for investors to get back to where they started last year, post inflation. That would be a decent performance by historical standards.
Despite that, there is a caveat that is important to note. In both the 1973 and 1980 declines—and in every recession and major downturn since—bonds far outperformed stocks. The simple reason for this is that during a recession, interest rates and inflation tend to fall to low levels as the economy contracts, reducing the risk of inflation eating away at the buying power of your fixed interest payments.
Source: PIMCO, Oct 2022
2022 was the worst year for financial markets. This time around, stocks and bonds have fallen together, with Bloomberg Barclays Global Aggregate indices down about 16% from their high in January last year, and benchmark 10-year treasuries down 16% (in price terms) since then, both with income reinvested.
Treasury yields are one of highest yields since 2008
Source: Silverdale, Statista, Bloomberg, Compound Investor, Dec 2022/ Feb 2022
The US Headline Inflation is down from 9.1% in May 2022 to 6.4% in the beginning of 2023. Shelter which consists of 40% of core inflation is on a firm path of decline. But for energy (which is currently deflator) and unemployment (which is the cause of concern), the inflation is gliding down.
Headline Inflation down from 9.1% (Jun’22) to 6.5% (Dec’22). Core Inflation remains elevated near 6%
Source: Silverdale, Bloomberg, Jan 2023
Even unemployment is reasonably contained (even though most of the new jobs since March 2022 are 'part-time' jobs and per hour wages are coming down), less lay-offs in Dec-Jan were not carried forward to Feb. Having said that, a structural short-fall of 1.1 million jobs cannot be resolved in the short run.
What we know is that when the US CPI falls by 1%, the US Bond Aggregate Index on an average provides 6.1% returns.
CPI YoY decreases > 1%
Bloomberg US Aggregate Bond Index returns > 6%
Source: Silverdale Research, Bloomberg, Doubleline Capital, Dec 2022
Initial bond yield is the most reliable indicator of bond returns. Right now, yields are at a record high. A simple linear regression of opening bond yield at the start of the calendar year and the total bond return during the year for the period 2001-23 shows 10%+ return for 2023 based on the starting yield of ~4.2%. See below for illustration.
Source: Guggenheim Investments, Bloomberg 2023
In the past, it took a very long time for stocks to catch up with bonds. That’s because stocks were so overvalued. A bond investor was ahead for 13 years after 1973, and seven years from 1980, when using the Bloomberg Treasury index. It might come as a surprise to those who saw the value of their treasuries trashed by inflation last year, but from the 1973 and 1980 stock-market highs, bonds proved more resilient than stocks in both inflation shocks, albeit still falling far behind inflation.
What does it mean for you??
Circling back to where we started, it simply means that you should care and invest in fixed income.
Welcome to the first newsletter of the Female Bond Fellowship Newsletter! I’m happy you’re here :)