Is The Sky Falling Down?

It’s a challenging and unnerving time for investors

The recent sell-off we’ve experienced within the bond market has been extreme in both speed and magnitude

Coupled with falling equity markets, investing through 2022 has been a difficult experience

---

This journey has been especially painful for lower risk investor portfolios.

Following a stellar run over recent years, it’s been a terrible year for global bonds. An annus horribilis as our late Queen famously said.

Showing their worst performance in decades, global bonds entered their first bear market in a generation.

This saw portfolios with greater allocation to bonds – those portfolios labelled lower-risk and therefore expected to insulate in times of market corrections – fare particularly badly as they fell broadly in line or more compared to higher risk models.

The graph below shows the returns over the last 12 months from the UK Stockmarket compared to UK Gilts. I feel this graphic lays bare and helps clarify the reason for the difference in performance of higher risk and lower risk portfolios than any long-winded explanation.

But with higher yields now available, there’s increasing room for future optimism.

Following the sell-off, yields are now looking increasingly attractive.

Source: Bloomberg and J.P. Morgan Asset Management

Additionally, with government bond yields now greater than equity earnings yield in the US, and on a par in the UK, the relatively defensive role historically provided by fixed interest to investors may be back in play.

To use two well-worn investment acronyms, TINA (there is no alternative) has been replaced by TIAA (there is an alternative).

The fixed interest opportunity is not without risk though. While yields have risen meaningfully, central banks remain fixated on getting inflation under control, so additional interest rate rises are widely expected.

As we can see from the graph below, US rates are expected to reach over 4.5% by the end of 2022 before peaking late in Q1 2023, and the UK following a similar path but expected to reach over 5.5% later in 2023.

Source: Bloomberg and J.P. Morgan Asset Management

It’s important to remember that a lot of the negativity in the news is already priced in. The losses aren’t based on what’s happening right now, but on what markets think will happen over the next few years. Of course, the idea that interest rates might reach 5 or 6% over the coming months or year is worrying, but the market has already reacted to that. Future gains or losses will be predicated on whether or not expectations are realised.

What Next?

So, whilst negative returns within portfolios does not feel great, crystalising them has the potential to be worse. Even with higher interest rates, there's currently little chance of beating inflation in cash, or accurately timing the re-entry point.

“Buy and hold” and focusing on “time in the market” are regularly quoted adages, but it’s because they continue to be true.

On balance, markets tend to go up over the long run and market volatility does tend to be relatively short lived.

I've written before, several market studies considering the longer-term time horizon show material underperformance of portfolios missing out on just a dozen of the best trading days when compared to those staying the course through market’s ups and downs. Miss out on more that the best ten days and the results get exponentially worse.

So, in summary, the sky is not falling down, it's just very dark and cloudy.

Bond prices will still be susceptible to further short-term falls, and that will be particularly felt in the UK where uncertainty has never been higher.

But with the yield curve currently inverted, there is only one logical direction for long term bond returns from here and that is up.

Uncertainty is inherent in investing. You need it to drive long term returns. And if you look back, points of pain or stress in the market can often be the times of long-term opportunity.

Remaining patient, long-term and disciplined is arguably more important than ever at this time of heightened volatility.