Bonds’ Day of Reckoning

One of RBA’s axioms of investing is that markets do not care about the levels of economic statistics. Rather, markets move based on the change in those statistics. The entire concept of a cycle is based on the economy improving, peaking, deteriorating, and troughing, and not on absolute levels of growth. “Good” or “bad” doesn’t matter; markets care about “better” or “worse”.

We re-structured our bond holdings during mid-year 2016 because the inflation backdrop began to change. The absolute level of inflation was low, but many indicators began to suggest that inflation could rise. It seemed to us that bond returns could suffer if inflation began to rise more than investors expected.

In retrospect, our timing was fortunate. Bond returns have suffered as inflation expectations rose. As Charts 1 and 2 point out, bonds have underperformed stocks by more than 35 percentage points since inflation expectations troughed in June 2016. In fact, bonds have barely produced positive returns since inflation expectations troughed.

Flows into bond funds and ETFs (see Chart 3) indicate investors have generally ignored bonds’ underperformance or perhaps considered the underperformance temporary. However, the business cycle isn’t dead, and inflation has begun to rise as it normally does in a late-cycle environment. Bond investors’ ostrich-like strategy to this shifting environment suggests that bonds’ day of reckoning may be upon us.

CHART 1:
Inflation Expectations: 5 Yr 5Yr Forward Breakeven
(Weekly, Jan. 18, 2013 – Jan. 11, 2018)

Source: Richard Bernstein Advisors LLC., Bloomberg Finance L.P.