Here’s the scene: It’s March, 2022 – one year ago – and the U.S. consumer price index is rising toward a four-decade high of 8.5 per cent. The Federal Reserve has just raised its key interest rate for the first time since 2018, in recognition of “elevated” inflation.
And investors are scrambling for approaches that will see them through what could be a tumultuous period for stocks and bonds. Few pursued what, in hindsight, would have been a smart strategy: Diving into British stocks, while avoiding gold and Treasury Inflation-Protected Securities (TIPS) in favour of high-yielding bonds.
A year into this extraordinary period for investors, defined by stubbornly high inflation, aggressive central bank rate hikes and ominous signs of a coming recession – little of which could have been predicted a year ago – the market’s response has been surprising in a number of ways.
For one thing, U.S. stock valuations have remained lofty, based on their estimated price-to-earning ratios, even as rising interest rates hammer fast-growing technology stocks and weigh on major indexes.
“Sure, equity forward P/Es have fallen from their early 2021 crazy highs,” Ray Farris, chief economist and chief investment officer for the Americas at Credit Suisse, said in an e-mail.
But, he added, the current valuation for the S&P 500 is higher than prepandemic average levels in 2018 and 2019 and much higher than he would have expected given the Fed’s aggressive rate hikes.
Meanwhile, global winners emerging from the shift away from growth stocks may not have been obvious a year ago. Britain’s FTSE 100 index has risen 10.3 per cent over the past year, and Japan’s Nikkei 225 isn’t far behind with a gain of 9.7 per cent.
Both indexes are widely viewed as cheap among developed markets. Still, for British and Japanese benchmarks to outperform the S&P 500 – which contains plenty of value stocks – by about 17 percentage points over the past year would have been a tough call.
Among Canadian stocks, unprofitable Bombardier Inc. has more than doubled over the past year. But dividend-generating utilities have slumped 13.6 per cent, suggesting that safer bets are hardly rock-solid in this environment.
The price of gold may have surprised some investors too. Though widely praised as a hedge against inflation, it has been sensitive to the rate increases that have followed. Gold is down about 8 per cent over the past year.
And then there is the bewildering bond market, or at least parts of it.
It is hardly surprising that bonds have struggled as central banks raised interest rates: As rates rise, bond yields follow, sending bond prices down. Popular bond exchange-traded funds are nursing double-digit losses over the past year.
But investors who flocked to TIPS – U.S. government bonds that are indexed to inflation – as a buffer against soaring consumer prices have encountered even bigger disappointment.
The iShares TIPS Bond ETF, for example, has slumped nearly 17 per cent over the past 12 months, which is worse than the performance of bond ETFs with more sensitivity to inflation. The iShares Core U.S. Aggregate Bond ETF, which tracks the total U.S. investment-grade bond market, has done better: It has fallen just 11 per cent over the same period.
High-yield bonds, issued by companies with credit ratings that are below investment-grade, offer another surprise: ETFs tracking these economically sensitive assets have been holding up relatively well.
This is unusual, given dark economic signals: Short-term government bonds are yielding more than long-term bonds, a condition known as an inverted yield curve, offering a strong indicator of a looming recession.
Normally, this outlook would weigh on high-yield debt. But not now. High-yield bond ETFs, though down, have been outperforming safer, lower-yielding bonds over the past year.
David Kletz, lead portfolio manager at Forstrong Global Asset Management, noted that the difference – or spread – between the yields of safe government bonds and riskier high-yield bonds should have widened amid concerns about the economy.
Instead, spreads are narrower than the long-term average. That, Mr. Kletz said, “seems to fly in the face of what the yield curve is telling you, which is to prepare for a recession.”