Economic & Market Report: Why Bonds? Why Now?

September 4, 2023
Featured image for “Economic & Market Report: Why Bonds? Why Now?”

The U.S. stock market has had a banner year so far.  The S&P 500 is higher by double-digits year-to-date, and what was shaping up to be a lousy August has been surging back toward breakeven as the month draws to a close.  But while stocks continue to mend following a particularly difficult 2022, the bond market rebound has been far more muted.  Long known as the portfolio ballast through stock market storms, such was not the case for bonds last year.  And their lagging performance so far this year raises worthwhile questions.  Why bonds? And why now?

Inflation pressures are receding. A primary reason that stocks have been rallying so far in 2023 is the fact that the U.S. economy’s scorching case of inflation continues to fade.  But it is equally important to note that inflation is a primary determinant of bond returns, thus bond prices should also benefit as pricing pressures wane.

After peaking at nearly 9% in mid-2022, the annual inflation rate has been steadily coming down the other side of the mountain.  Today, headline inflation has fallen back toward 3%.

While it would not be surprising to see the annual inflation rate bounce back and forth in the 3% to 4% range through the remainder of the year, investors can find reassurance from the 5-year breakeven inflation rate.  Providing a read on expected average inflation over the next five years as priced by the marketplace, breakevens are continuing to fade in their own right back to the 2% target level that the Fed talks so much about.

Thus, the fact that current inflation continues to fade and expectations for future inflation are even more subdued provides a notable tailwind for bonds going forward.

Attractive relative value. Another factor in support of bonds in the current market environment is their attractive value relative to stocks.  It was not long ago that the 10-Year U.S. Treasury yield was chronically stuck below 2%.  And it had been more than a decade since the last time we saw a 10-Year U.S. Treasury yield north of 4%.  For 2-Year U.S. Treasuries, it had been even longer.  But today, we have the 10-Year yielding as high as 4.3% and the 2-Year topping out over 5%.  And with a U.S. Federal Reserve nearing if not already at the end of their ultra-aggressive rate hiking cycle at a time when pricing pressures are continuing to fade, we may not see bond yields extend much higher than they already are today.

So what about the relative value to stocks?  The S&P 500 is currently trading at 24.4 times trailing 12-month GAAP earnings.  And if we price stocks today based on future earnings expectations over the coming year, the S&P 500 is still trading at a lofty 21.3 times earnings.  If we invert these P/E ratios, we are left with earnings yields of 4.09% on a trailing 12-month basis and 4.70% on a forward 12- month basis.  Comparing these S&P 500 earnings yields to the 10-Year U.S. Treasury yield at was up at 4.36% earlier this month and is still at 4.12% today, we see that investors are receiving little to no premium over Treasuries today (if not taking a marginal discount) to take on the various additional risk of owning stocks.

Recession protection. All of the above so far assumes that the U.S. economy continues to roll along full steam ahead as inflationary pressures continue to fade.  Of course, it was not that long ago that investors were understandably wringing their hands about the threat of an economic recession this year or next.  And while these recession fears continue to fade, we are certainly not without measurable risks to the outlook.

Indeed, bonds did not provide a portfolio ballast when inflation was surging.  But if the economy falls into recession, this slowdown scenario is much more likely to be disinflationary if not outright deflationary, which is decidedly negative for stocks but is a positive backdrop for bonds.  This is particularly true of U.S. Treasuries, which come with virtually zero default risk and are highly liquid, thus serve as a safe-haven destination for global investors during periods of economic turbulence.

For example, long-term U.S. Treasury bonds surged over +35% both during the bursting of the tech bubble from 2000-02 and again during the financial crisis from 2007-09 when stocks lost more than -40% of their value, and they jumped +20% during the onset of the COVID crisis in 2020.  As long as inflation expectations remain in check, investors should reasonably expect bonds in general and U.S. Treasuries in particular to return to their historical portfolio diversification form.

Bottom line.  While investors may still be understandably smarting from bond market performance during what was already a difficult time for stocks in 2022, investors are likely to be well served to continue to stick with the asset class.  Inflationary pressures are on the wane, relative valuations are attractive, and U.S. Treasuries in particular still maintain their identity as a safe haven destination for capital during times of economic, market, and geopolitical stress.

Compliance Tracking #: 473669-1

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice.  All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.  Please consult a tax or legal professional for specific information and advice.

author avatar