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Is the bond/equity seesaw broken?

In a high-inflation environment, bond and equity movements may continue to defy expectations

Many investors continue to allocate their assets in a 60/40 split between stocks and bonds. Equities carry greater risk, but offer the potential for greater long-term reward. If equities falter, the theory goes, bonds will rise to the occasion and provide a safe haven to carry the portfolio to better times. But in the unsettled economic environment of 2022, bonds and equities have defied expectations by rising and falling in tandem.

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Is the reliable bond/equity seesaw suddenly broken? Not really, says Ian Marthinsen, portfolio strategist, Lysander Funds Ltd., an experienced Canadian independently owned investment fund manager. No more than a real seesaw launched into space can be said to be broken – it simply won’t function in zero gravity.

“In 2022, the bond/equity seesaw has defied expectations in the rarefied air of extremely high inflation,” he says. “We haven’t seen this level of inflation since the 1970s and 80s, so for many market participants it’s a major paradigm shift.”

What happens next is a matter of debate between bulls and bears, who both often look to the past for future guidance.

In the bull camp, investors are looking for another “Powell pivot”, a U-turn in monetary policy occurring in January 2019. At that time, Federal Reserve chair Jerome Powell pivoted from hawkish rate increases and put a pause on future increases in the overnight rate. Bull campers believe inflation will dissipate naturally and hope that another Powell Pivot will result in a bond and equity market rally.

“But the key difference between early 2019 and today is the level of inflation, which hovered below two per cent then, but is sitting above eight per cent now,” Marthinsen says. “If Powell has a reason to pivot now, it certainly won’t be because inflation is under control.”

Those in the bear camp are looking back to the 1970s and 1980s, when then-Fed chairman Paul Volcker raised interest rates aggressively to cool record-setting inflation — even at the risk of recession.

“If you’re in this camp, then time is of the essence in bringing down inflation,” Marthinsen says. “If you do it gradually, the idea of persistent inflation becomes engrained in our psychology. People will come to expect wage increases to keep pace. That increases purchasing power, which keeps demand up and results in a wage-price spiral.”

Both bulls and bears saw their scenarios played out in 2022. In the first half, bears had their way — and stocks and bonds declined in tandem. In July, bulls were vindicated — and stocks and bonds appreciated in tandem. In both cases, the bond/equity seesaw failed to reassert itself in traditional fashion.

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What made the 1970s and 1980s different?

“In the Volcker years, with interest rates at 15 to 20 per cent, bond coupons kept pace,” Marthinsen says. “Those coupons offered a moat to investors and largely prevented bonds from going into absolute negative returns against inflation.”

But today, with prevailing interest rates still relatively low, bond coupons have not kept pace with inflation. With 10-year U.S. Treasuries at about 3.5 per cent, there’s only a very small cushion in place before inflation causes bond returns to fall into negative territory. If generous coupons are no longer the great equalizer of bond volatility, they tend to move with the same sensitivity as equities, he says.

So if the bond/equity seesaw is currently out of commission as the result of the current inflationary environment, does that mean investors should abandon bonds altogether in the short term?

“One of the reasons for balancing a portfolio is to mitigate overall risk,” Marthinsen says. “Maybe this is not the environment to be in a passive bond like an aggregate bond index that has a lot of duration. That’s why the current high-inflation environment lends itself to active managers so well.”

One of the risk-mitigation strategies currently employed by Canso Investment Counsel, the portfolio manager for certain Lysander Funds, involves lowering overall exposure to bond duration.

“A passive index has a duration of six to seven years with a current average yield right now around four per cent,” Marthinsen says. “If an active manager can get similar yields over a shorter duration, then it mitigates exposure to the risk of future inflation.”

While the current high inflation environment may have temporarily disabled the bond/equity seesaw, he notes, active management and reduced exposure to inflation risk can at least continue to restore some sense of balance to bond-equity asset allocation.

For a more detailed examination of the 2022 bond and equity market, please see: 2019 Bulls versus 1970s Bears: What Does it Mean for Investors in 2022?

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For more information on Lysander Funds, visit: www.lysanderfunds.com

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

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This story was created by Canadian Family Offices’ commercial content division, on behalf of Lysander Funds Limited.