The Market Update by Tim
The start of 2022 has been pretty unusual for investments – and not in a good way.
Both stocks and bonds finished the quarter in negative territory, with bonds dropping a hefty 6% while stocks (S&P 500) were down almost 5%.
What gives? Have bonds lost the ability to act as a stabilizer? Are the benefits of diversification gone?
Not so fast. Diversification works, but it doesn’t work perfectly. (Investing has just never been that easy.) Combining stocks and bonds will smooth some of the fluctuations in a portfolio over time, but time has always been a key factor.
Spikes in correlation (i.e. moving together) for stocks and bonds are not uncommon, and history shows that inflation shocks are one factor that can result in investments moving downward at the same time.
High inflation is often followed by higher interest rates, as the Federal Reserve will typically raise rates in an effort to cool down the economy. Rising interest rates cause bond prices to fall, since existing bonds become less attractive relative to newer bonds with better yields. Things are more complicated for stocks, but stocks may also be impacted negatively as rates increase, as slowing economic growth becomes a concern and bond yields become relatively more attractive.
With additional rate increases in the works, is it time to abandon bonds?
Here are a few reasons that would not be wise:
- Markets do a good job of incorporating information quickly. Future rate increases have been signaled by the Fed and will not be a surprise. It’s already part of the current market psychology.
- Falling bond prices mean they are a better value and now offer higher yields. The outlook for bonds has improved as more interest income will be collected in the future.
- Bonds remain far less volatile than stocks and serve to offset major market declines. A stock market drop of 10% or more has occurred in 10 of the past 20 years, and stocks were down 13% year-to-date as of mid-March. Conversely, the 6% decline for bonds ranks as one of the worst calendar quarters in decades.
- The future is always hazy, and the Federal Reserve could change course quickly with the shifting sands of the economy. Four months ago, economic forecasters were predicting inflation of just 2.4% this year, and inflation was dismissed as “transitory” by the Fed. How quickly things change…
Recent performance doesn’t negate the benefits of diversification across asset classes. Bonds may not be the perfect diversifier, but they play an essential role in the portfolio and remain one of the best tools we have to moderate risk. Don’t let the short-term bumps ruin a long-term strategy!
Let us know what questions you have!