As we discussed in the last article, equities and bonds typically perform differently in different market conditions which is why this strategy has had a long track record of success. In 2022, however, this investment strategy performed poorly, with the defensive and growth components both losing value. Does this mean the strategy is no longer viable?
We think not as 2022 was a unique year where the main driver of markets was inflation. While this is nothing out of the ordinary, the type of inflation we experienced is uncommon and produced an unusual reaction from markets. 2022’s performance is reviewed below, before we consider different types of inflation and how they affect markets.
The typical relationship between equities and bonds broke down in 2022
Over the long term, equities and bonds have either a low correlation (their movements are not closely linked) or are negatively correlated (as one asset class falls the other rises). While there have been many years when both asset classes have risen in value, one usually produces much stronger returns. Recent years have seen bonds and equities produce loosely opposing performance. For most of this time bonds lagged while the ‘better’ performance came from equities. Gilts have typically been stable and when equity markets struggled they maintained value and limited losses. Equities have been the volatile, return-generating tool. Poor performance patches have been much more common, and accepted, as over the longer term the good times outweigh the bad.
Source: FE Analytics, Nov 2022
This past year was the opposite; ‘why are gilts more volatile than equities?’ and ‘why are they becoming more highly correlated?’ were common and reasonable questions.
Inflation is the short answer. Usually periods of high inflation are driven by high levels of economic activity as lots of money flows through the economy, business earnings boom and high levels of employment means lots of spending/demand. If this results in too much money chasing too few goods this drives up prices. This is demand-based inflation. High levels of inflation raise the requirements for higher interest rates, which devalue gilts.
But demand was not the main inflation driver in 2022. If we can understand the different types of inflation, market moves will be more understandable.
Instead of demand-side inflation, rising costs drove a lot of the inflation we saw in 2022. These rises came from the supply side of the economy, or the supply of certain goods/inputs into the economy.
During the pandemic there were well documented supply chain issues, as lockdowns meant companies could not produce goods fast enough and shipping companies could not transport them fast enough. This limited the supply of goods and pushed the price up.
We have also had an energy crisis which added to these problems. A recovery in demand for oil and gas after the coronavirus crisis was followed by Russia’s invasion of Ukraine and this meant energy became very expensive. These higher costs then generally get passed onto consumers through price rises and have pushed the price of goods up.
This is more problematic than demand-led inflation, where consumers are driving the inflation because they are earning more. In a supply-side scenario, consumers are simply forced to bear the brunt of higher prices of nearly all goods and services despite no additional earnings. Consumers have to limit spending as their money does not go as far. This adds to the problem as companies then start to earn less, potentially needing to lay workers off, and the cycle continues to develop. Dealing with the issue is tough too. The traditional response to inflation is to tighten fiscal and monetary policy, increasing interest rates and decreasing money supply. However, these policies are targeted at reducing consumer spending. They do not solve supply chain issues which are much less controllable.
How does this affect a 60/40 portfolio?
When we experience demand-side inflation, company profits are strong. We may have interest rate rises to control inflation, which would mean underperformance for gilts. However, equities can still post positive profits and therefore good returns.
In contrast, supply-side inflation sucks money out of the economy as consumers spend less and companies earn less and this is a drag on equity performance. At the same time, interest rates will still rise to try and tackle inflation, so gilts will still fall. Ultimately, the negative performance of gilts is not offset by strong equity performance.
This year the poor performance has been amplified too. Energy prices have been particularly volatile due to the war in Ukraine. Putin has used energy as a weapon against European countries in the hope they would give in to his demands. This pushed inflation to extremely high levels, so very high interest rates lowered the value of bonds.
Bonds and equities have reacted as we would expect in the current environment - so it is not a problem with the fundamentals. This rare type of inflation is the key reason for the performance of bonds and equities; it explains the poor performance of the 60/40 strategy in 2022. Nonetheless, it is still an inflationary period in an economic cycle. Market cycles go through periods of stress and more supportive conditions will return. For example, the oil price shock in the 1970s is another example of a supply shock and this was a temporary part of the cycle.
In the next article we look at how to categorise these periods in a market cycle, if they are a persistent or passing event and the impact they can have on a 60/40 portfolio.