Since the late 1990s, stocks and bonds have mostly been negatively correlated, meaning that when one goes down, the other goes up, and vice versa. When stocks sold off, bonds usually bailed you out. This has been extremely valuable to investors and has been an underlying assumption in many portfolios. The regime shift to a higher and more volatile inflation environment shattered this assumption.
The US stock market fell 18% last year. With inflation over 6%, it was a bad year for equity investors. But it wasn’t one of the worst – six have had the worst performance since 1926. What sets 2022 apart is that long-term government bonds had their worst year at the same time, falling short inflation of almost 33%. A portfolio of 60% US stocks and 40% long-term US government bonds would have underperformed inflation by 28% in 2022.
The bond sell-off was fueled by rising government bond yields (prices fall when yields rise) and credit spreads. The result is that bonds are offering considerably higher yields than a year ago.
Over 60% of the global investment grade corporate bond market now yields over 5%. 12 months ago, only a quarter of a percent did.
You can get around 5.5% on short-term investment-grade US corporate bonds. Yields would need to rise another 2% for investors to take losses. A year ago, it would have taken only a 0.5% increase for the same result. This “margin of safety” against potential losses due to future increases in yield has increased dramatically.
For investors willing to take on more risk, high yield lives up to its name for the first time in a long time, with a 9% return. Hard currency emerging market debt is not far behind.
Bonds are back on many investors’ radars.
At one point, almost 30% of the global fixed income market offered investors a negative yield. The government bond market was the worst offender; the proportion in this market was over 40% in August 2019. There were even high yield bonds trading at negative yields.
Investors who bought them and held them to maturity were guaranteed to get back less than they invested, at least in nominal terms. Many will breathe a sigh of relief that they are all but gone.
Many income investors have shunned bonds in favor of stocks. It will be interesting to see if that reverses now that corporate bond yields are significantly outpacing dividend yields in many markets.
House prices may have been high relative to incomes in recent years, but low interest rates have kept mortgage payments relatively affordable, even for those borrowing large amounts. The challenge was not the monthly payments, but obtaining the deposit. With mortgage rates soaring, those days are now over.
With a mortgage rate of 2%, the monthly repayment of a £300,000 UK property purchased with a 10% down payment and a repayment term of 25 years would have been £1,144. At 6% that would be £1,740, over 50% more. Potential buyers must either find more money, lower their expectations, or prices must drop.
Very roughly, it would take about a 30% drop in price in the example above for monthly payments to be similar to before.
Overall, existing owners are not as immediately affected. Fixed-rate mortgages have grown as a share of total mortgage debt outstanding in the UK and are overwhelmingly dominating in the US. Higher interest rates will only have an impact when they need to refinance or relocate. But, unlike in the US where mortgages are fixed for 30 years, fixed terms in the UK are usually only two to five years. There is respite but it is more limited in time.
Having been one of the worst performers for most of the past decade, the UK has emerged head and shoulders above the rest in 2022, with the US falling to the bottom of the rankings.
While 2022 disappointed when it came to the diversification benefits of holding stocks and bonds, it highlighted the value of diversification within equity portfolios. Many of the trends that had been in place in equity markets since the pandemic (and before) have reversed. Investors had also, in many cases unwittingly, taken outsized bets that they would continue.
The United States accounts for almost 70% of the global developed equity market and the US market has, until recently, been increasingly focused on mega-cap growth companies. When growth stocks fell, the United States fell. And when the US fell, global portfolios were heavily exposed.
But concentration is not just an American characteristic. Five companies account for more than a third of the UK market and only ten account for more than half. Within emerging markets, the three major Asian markets of China, Korea and Taiwan represent 57% of this market. At one point in late 2020, that figure was 67%, while China alone accounted for 43% (currently 32%).
It is very important for investors to understand the concentrated exposures they are taking when allocating to broad equity indices. This can be in terms of stock, sector, style or region. Achieving balance and diversification is unfortunately not as simple as investing in a global equity portfolio.
Our analysis of the text of US corporate earnings reports (above) highlights a striking increase in corporate discourse on “reshoring”. Companies are considering diversifying their production – and relocating it closer to home.
This means that one of the great deflationary forces of the past decades, China’s low-cost output growth, is weakening and may have run its course. Globalization may still play a role in lowering costs as production moves to new countries, but the easy wins are over as companies increasingly value security of supply.
The Russian-Ukrainian conflict has caused a major global energy crisis. Prices soared as Russian supply came under sanctions. This has inflicted financial hardship on many households and businesses, with Europe being the epicenter.
However, another, more positive consequence has been an acceleration in the expected rate of expansion of renewable energy. Already benefiting from the tailwinds of the global energy transition, high fossil fuel prices have further improved the economic attractiveness of renewables. And Europe in particular has sought to break away from its historical dependence on imported Russian gas. Energy security has become a high priority. This further supports the demand for domestic energy sources, with renewables expected to play a major role. In some cases there will also be an expansion of domestic fossil fuel capacity, for example coal mines in Germany are being brought back into service and planning approval has been given for a new coal mine in the UK. However, this has not dampened the ambition of the renewable energy plans, which have proven to be clean, safe and not tied to raw materials.
Compared to what was projected a year earlier, there has been an increase of almost 30% in what is projected for global renewable energy capacity in 2027. This would translate to an increase of almost 75 % of global capacity between 2022 and 2027. According to the IEA, “China, Europe, the United States and India are implementing existing policies, regulatory and market reforms and new policies faster expected to tackle the energy crisis”. China is now on track to meet its 2030 wind and solar energy targets by 2025. Implementation challenges should not be downplayed, but, driven by necessity, 2022 has been a transformational year for plans regarding the role of renewables in energy security.
We will publish a series of articles in the first quarter on the ongoing regime change. The first, an overview of what we consider to be the five most important macroeconomic trends driving this change, is available here. Future research will delve deeper into each of the individual trends and the investment implications.
