Morningstar - Q2 2023 - 30

Spotlight: Bonds
experienced losses in tandem around 30% of the
time on a monthly basis and 15% of the time
on an annual basis. " It's not unprecedented for
equities and bonds to go down together, "
he says, especially as inflation has heated up
to decades-high levels over the past year.
Inflation Isn't the Only Problem
Decades-high inflation may have been the primary
problem for the 60/40 portfolio, but there was
another important variable: near-zero interest rates
at the start of 2022.
Because of the way bond pricing works, the
three-decade decline in interest rates that
lasted through 2021 meant that bond valuations
were extremely high at the start of 2022, so
they had a lot of room to fall.
The key, Fidelity's Timmer says, was those
starting valuations: " When it comes to bond
performance, interest rates rising from
zero to 4 is an entirely different equation than
interest rates rising from 4 to 7. " Bond
performance will always suffer when interest
rates rise, but starting from zero is " an entirely
different ballgame. And that's what led
to extreme losses for bonds in 2022, " he says.
However, " Last year was a hundred-year storm, "
Timmer says. " If we go back in history, we
cannot find this kind of juxtaposition with equity
and bond returns both being as low as
they were. "
Where Will the 60/40 Go From Here?
In the near term, the key to how 60/40
diversification works for investors could be the
degree to which inflation continues to decline
from the four-decade highs seen last year.
Timmer says that the near-term outlook for
bonds-and diversification-depends
on the macroeconomic environment. Specifically,
he says, whether the Fed can engineer
a soft landing for the economy and avoid a
recession, as well as its success in bringing
down inflation. " Either way, though, the
bond landscape has reset itself " to higher yields,
he says. " That's a much better starting point
for the 60/40. "
30
Morningstar Q2 2023
Income Is Back in Bonds
Capital Group's Queen echoes the importance
of higher yields.
" We may not have quite the strong negative
correlations anymore, but now, we've
got some income " from bond yields well above
inflation, he says. " I really do think it still
makes sense to think about diversification and
balance in portfolios. "
Fidelity's Timmer says that with interest rates
so low before 2022, " there were very few
reasons to own bonds other than their negative
correlation against stocks. " When interest
rates were near zero, " investors would
actually lose purchasing power by owning bonds, "
he says.
But now, higher yields mean investors are back
to earning income from bonds. " Today, you're
getting paid to own bonds because real rates are
positive, " Timmer says.
By the end of last year, two-year Treasuries
were yielding 4.41%-over 5 times higher than the
0.78% at the start of 2022. The 10-year Treasury
yield rose to 3.88% from 1.63% at the start
of the year.
A New Economic Regime Calls for an
Adjusted Asset Mix
BlackRock's Li expects a significantly different
economic landscape than the one investors
were used to before 2022, but one that
should still see a better outcome for bonds
as a diversifier.
" In 2023, inflation will fall quickly, but it will
settle at a level higher than what we've been used
to, " she says. " We're entering a new environment
where the 'goldilocks outcome'-equities
and bonds both staging multidecade bull markets
alongside each other-is over, " she says. " It
is 'either-or' in this world of tougher trade-offs. "
Li says investors are entering a new regime
of higher market volatility and tougher
macroeconomic conditions that's very different
from those in place since the mid-1980s. That time
was known as the " great moderation, " when
economic cycles were more muted. Importantly,
during the great moderation, the ups and
downs of the global economy were driven by
fluctuations in demand, which had significant
implications for monetary policy.
" The tools of central banks-namely, interest
rates-are very effective in addressing the
demand side of the economy, " Li says. During the
great moderation, the central bank effectively
mediated economic excess and recession,
according to Li.
But now, she says, the dynamic has changed.
" We are in a new regime shaped by supply
constraints, " she says, " making the central banks'
response mechanisms even more important
for markets. "
The current environment is shaped by several
factors, Li says, including geopolitical
fragmentation, the net-zero transition, labor
shortages, and a series of supply chain
challenges-all of which have an impact on the
supply side of the economy.
" In this environment, the Fed can either choose to
crash growth, or live with this supply-driven
inflation, " Li says.
Either way, she says, stocks and bonds
won't be sharing in a multidecade bull market
any longer. " The central bank's response
will determine whether equities suffer
or bonds suffer. "
This new environment has implications for the
60/40 portfolio and how investors should diversify,
Li says. " The mix of the portfolio matters a lot
more in this environment, " she says. " Our research
shows that the equity/bond mix will matter
4 times more than it did before. Getting your mix
correct and not letting your portfolio drift is
more important than ever. "
Strategic vs. Tactical Asset Allocation
Critically, Li says, it's a time that investors should
be more dynamic with their asset allocations.
That's the case for both strategic asset allocation
and tactical asset allocation. Tactical asset
allocation-individual security selections and
Morningstar - Q2 2023

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