The Fed’s muscular effort to bring inflation under control has had repercussions across the investment spectrum. For example, one important effect is that high-quality fixed income is now a more credible alternative to equities. On October 25 the two-year Treasury yield stood at 4.47%, up from 0.73% on December 31, 2021. The last time prior to 2022 that the rate was at that level was 15 years ago.
We know that August 9, 2007, was not an especially good moment to jump into any kind of financial asset. The Great Recession of 2008-2009 followed soon afterward. Currently, however, we see no potential catalyst for a banking crisis of the sort that transformed the 2008-2009 downturn from a run-of-the-mill recession into the deepest one, by several measures, since the Great Depression of the 1930s.
Our current assumption is that the U.S. will experience a mild recession in 2023. In light of that outlook, let us consider the last time before 2007 that the two-year Treasury yield stood at about its present level—4.48% on April 16, 2001. An eight-month recession of comparatively mild severity began that month. Over the subsequent four-year period, the two-year Treasury dramatically outperformed equities. Through April 16, 2005 the respective annualized total returns were 5.92% and 0.86%. Even after five years, the default-risk-free, low-term-risk government bonds were still ahead, 5.42% to 3.53%.
We do not interpret this historical precedent to mean that holders of balanced portfolios should abandon equities. Neither should Treasury bonds, in our view, be the primary asset within an income portfolio. Over the intermediate term, moreover, there can be no assurance that interest-rate-sensitive instruments lack remaining downside. We do, however, believe it is likely that from a vantage point a few years hence, 2022’s fourth quarter will prove to have been a very good time to increase fixed income allocations and extend duration.
Underlying that assessment is our expectation that inflation will ease, enabling the Fed to end its rate-hiking in the first half of 2023. This conclusion is not based on a simplistic notion that the present high rate of consumer prices increases is transitory and due solely to temporary supply chain disruptions. Housing prices have been falling in the face of rising mortgage rates and rents have begun to decline in some cities. A continuation of those trends would curb one of the most stubborn components of inflation, namely, the cost of shelter. Note that the Fed’s preferred inflation measure, the Personal Consumption Expenditure Index, is below its 7.0% June peak, at 6.2% in October.
Another reason to expand the fixed income allocation in a portfolio is that this year’s highly unusual coinciding downturns in stocks and bonds is very unlikely to be repeated in 2023. The long-run price correlation between the two asset classes is low to negative. Next year should follow one or the other of the following two scenarios:
1. A weakening economy induces investors to move assets from equities to the safety of bonds. Bond prices rise in response to the increase in demand.
2. The economy strengthens, causing investors to become less apprehensive about risk. Equities recover and spreads over default-risk-free Treasuries contract, producing favorable returns for corporate bonds and preferred stocks.
Fixed income also has favorable long-term dynamics militating in its favor. The total return of any asset class is a function of yield and price change. For fixed income, though, yield is the dominant factor over periods of several years. As detailed at the outset of this commentary, the rise in yields that has occurred this year creates higher prospective returns for fixed income than have been observed in many years.
2022 has been a very unrewarding year for investors. Both income and equity investments dropped sharply at the same time. It is impossible to time the market, but from this point onwards (starting with increased yields and lower valuations) the long-term expected returns for fixed income and diversified portfolios look pretty promising.
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