One of the most important investing questions today is whether the post-COVID period of higher inflation and correspondingly higher interest rates has been a short-term blip, with a return to the conditions of the prior decade or two likely, or whether COVID marked the end of one investing "regime" and the start of a new one.
This question has significant implications, largely because its answer determines the degree to which investors can continue to rely on bonds as the primary safety mechanism in building portfolios. The roughly 40-year bond bull market that began in the early 1980s saw interest rates decline in a fairly steady line, providing strong returns from bond portfolios.
Less obviously, inflation receding from high levels to the point where it barely registered as a concern in recent decades allowed central banks to aggressively foster lower rates (through both normal rate cuts and new policies like Quantitative Easing) whenever the economy or markets encountered rocky patches. With no inflation pressure, rates could be pushed aggressively lower, producing a bond boost that regularly cushioned equity volatility in balanced portfolios.
As we saw in 2022 however, that dynamic changed completely in the presence of significant inflation. In fact, it's reasonable to say that in 2022, a direct cause of equity distress was rising interest rates, which were themselves at least partially due to rapidly rising inflation.
So re-framing the opening question a bit, investors are left to ponder whether 1) the post-COVID investing climate is likely to feature higher inflation, 2) whether that higher inflation is likely to keep upward pressure on interest rates, and 3) if that new opposite dynamic for interest rates means the underlying framework of the 60/40 stock/bond portfolio construction has been undermined.
These are crucial questions that SMI has addressed in a number of articles and will continue to do so. It is, in fact, the central focus of SMI's March issue coming in a couple of weeks. It's not a stretch to say we've had our eye on this for a dozen years already, as the inability of bonds to protect balanced portfolios from a position of unnaturally low starting yields was the motivation for our (admittedly early) research that led to the Dynamic Asset Allocation strategy in 2013.
With all that in mind, I found the following excerpts from a recent podcast featuring Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, to be of particular interest (link to full episode of this Excess Returns podcast at bottom of article).
Interviewer: What [are] the biggest lessons [the] recent bout of inflation should teach investors?
Liz Ann Sonders: There were unique drivers to that bout of inflation, and that’s why we often talk about...the differences between this era of inflation and, say, the 1970s era.... [A]t the outset, it was driven by the pandemic and severe supply disruptions. It’s very different than the backdrop that existed in the 1970s.
That said...one of the most important shifts that is underway — of the secular variety, not...just short term — is I think we have exited the so-called great moderation era.... [That’s] the label that is regularly applied to the period from [the] mid to late 1990s through to the beginning of the pandemic. And it was an era...[of] essentially disinflation and or low inflation, [with a] generally benign interest-rate backdrop.
As a result of that, and maybe most important for investors, it was an era where, nearly the entire time, bond yields and stock prices moved in the same direction.... When bond yields, as an example, were going up, it was typically because growth was improving without the attendant inflation problem. That’s great for the equity market [and] vice versa....
I emphasized this because it's the key point. If the "stocks down, bond prices up" dynamic that helped investors so much from the mid-1990s to 2021 has changed, that has big implications for how we should approach portfolio construction going forward.
Liz Ann Sonders: I think we’re now — have already transitioned into — an environment that looks...more like the 30 years that preceded the great moderation.... And that was a period of greater inflation volatility. That’s not the same thing as saying inflation...stayed high for 30 years, but [there were] bigger swings in inflation, up and down.
There was also more economic volatility. Bigger swings — both on the upside and the downside — shorter cycles. You had more frequent recessions, you had more geopolitical instability. You had more volatility in commodity markets. I think that is more akin to the backdrop we’re in right now.
Importantly for investors, too, is the bond yield/stock price relationship was the opposite of what was the case during most of the "great moderation." During almost that entire 30-year period...stock prices and bond yields moved opposite one another. When yields were moving up in that era, it was often because inflation was reigniting — negative for the equity market.... So we’re back in that negative correlation mode right now, and I think if that persists, that would be...a more definitive sign that, yes, we are out of the great moderation era and we’re in a different era.
Sonders echoes the point we've made before that none of this means inflation is necessarily going to double-digits, or even that it will stick at some persistently high level. She highlights greater volatility of inflation — I've suggested that inflation fluctuating around a new "normal" of 3%-4% (rather than the 1.5%-2% of the past decade or more) with occasional spikes higher might be enough to produce the regime shift being discussed here.
More important is her suggestion that this higher and more volatile inflation is causing stock and bond prices to move together now. Many investors are surprised to learn that this was long the normal pattern — in the longer scope of market history, the 25 years or so from the mid-1990s to 2021 was the aberration, not the norm.
Recency bias is particularly dangerous in this case given the nearly complete recent re-writing of investing playbooks around the idea that stock and bond prices move in opposite directions, so adding more bonds can reliably be used as the mechanism to control portfolio risk. That worked brilliantly over the recent 25 years, but hasn't always — or even normally — been true.
Liz Ann Sonders: I also think — and it’s somewhat related, but it ties into some of these secular changes — you go in these long cycles where capital is more powerful than labor. I think we are transitioning into a cycle where labor is...increasing in terms of power and as a share — and this is more of a global comment than it is just a U.S.-specific comment. It has a lot to do with demographics....
I’m talking about these big secular cycles that have...to do with demographics and labor shortages, and working-age population versus retired-age population. Those are forces in play globally. That, I think, is starting to shift — to a little bit of a degree — that balance between capital/profits and labor as drivers of the economy.
This is one of the big secular (long-term) reasons to think we may have entered a new period of higher inflation (and higher interest rates). It's also a good place to leave this discussion for now. It's easy to jump from here to the other Trump 2.0 policies discussed in SMI's January cover article, given many of those have similarly broad potential impacts on inflation, interest rates, etc.
We'll discuss this important stock-bond issue in the upcoming March issue of SMI, including how to address this potential correlation shift in our portfolios.
