Investors who think owning a mix of bonds and stocks means they’re diversified may want to re-examine that strategy.
Or at least give their ear to Jim Bianco, president of Bianco Research LLC. He argues that both asset classes are poised to lose value when interest rates rise. Even though stocks historically stood to benefit from stronger economic growth, this time is different because the Federal Reserve’s unprecedented stimulus has sown the seeds for a surge in inflation, he said.
Rising borrowing costs “may just be the worst thing that could happen to risk assets,” said Bianco, who’s been circulating fixed-income commentaries for more than 20 years. “Be careful for all those people who want 3 percent yields; when you get that, you’re not going to like it because it’ll be because of inflation.”
Government bonds typically do well during periods of turmoil, which are bad for stocks. For example, as the financial crisis escalated in 2008, Treasuries gained 14 percent while U.S. stocks plunged 38 percent. The debt, often thought of as a safe haven, has benefited from the Fed’s almost six years of easy-money policies, gaining 19.3 percent since the end of 2009.
Here’s the odd thing: These bonds have gained value more or less in tandem with stocks this year. The notes have returned 4 percent while U.S. equities have gained 9.5 percent.
Since 2000, the correlation between U.S. stocks and bonds has tended to be negative, meaning bonds lose when stocks gain and vice versa. The 36-month rolling correlation of monthly total returns is negative 0.42, close to the lowest of the past 30 years, according to data compiled by Pavilion Global Markets Ltd.
With the two asset classes now moving in tandem, analysts and investors are scratching their heads and wondering whether it’s stocks or bonds that are poised for a fall.
“Can stocks and bonds continue to advance or will one asset class run out of steam?” Pavilion Global Markets strategists Pierre Lapointe and Alex Bellefleur wrote in an Aug. 25 report. “This is indeed an unusual pattern.”
Bianco says this trend is caused by equity investors succumbing to the idea that central banks will keep stimulating the economy until growth accelerates, which should help companies and nations boost their earnings and output.
Meanwhile, bond buyers are reaping the benefit of low inflation, with yields on 10-year Treasuries dropping to 2.38 percent from 3 percent at year-end. Inflation slowed to 1.6 percent in the 12-month period ended in June, below the Fed’s target of 2 percent, according to the personal consumption expenditures price index.
Bianco sees little reason for rates to meaningfully rise unless inflation picks up, and bond buyers are pretty sanguine about those prospects.
Traders predict prices will rise at an annual rate of 1.87 percent during the next five years, as measured by the break-even rate for five-year Treasury Inflation Protected Securities, a yield differential between the inflation-linked debt and Treasuries. That’s down from inflation expectations of 2.1 percent back in June.
There aren’t many signs of a downturn in stocks either. The Standard & Poor’s 500 Index reached the 2,000 mark this week for the first time, defying all the naysayers who’ve been calling for a correction.
But when inflation does start to meaningfully quicken, bonds and stocks will probably both lose value, since significant price increases aren’t good for either asset class.
“Right now all of it works, everything’s working,” Bianco said. “The flip side is inflation comes back, rates go up, stocks go down and nothing works.”
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