So far this month, stocks and bonds have declined together. This is once again calling into question the effectiveness of portfolio diversification. Despite all the academic research supporting portfolio investments which zig and zag differently, its benefits haven’t been seen lately. As of Thursday, the S&P 500 is down over 17% and a broad index of US bonds, the Barclays Aggregate, is down 10%. The declines have produced strange bedfellows: US Treasury bonds and growth stocks are both down double-digit percentages over these past few months.
Why are financial assets declining with Covid (mostly) under control, unemployment at 3.6%, households and corporations flush with cash, and the economy growing at a healthy rate? It turns out that the combination of high valuations, inflation, and a pivot in Federal Reserve policy is a gamechanger.
If we jump back to last October, there was an expectation that the economy would continue to heal post-Covid, inflation would be temporary, and the Fed would begin to normalize monetary policy – slowly withdrawing the stimulus supporting the markets for the last two years. The markets were strong (up nearly 27% in 2021) and things like cryptocurrency and NFTs (remember them?) were all the rage in the financial media, suggesting continued investor exuberance.
What changed? Stubbornly high inflation. Initially forecast to be short-lived (temporary worker shortages post-Covid, supply chain dislocations, etc.), over the last 3 months inflation has persisted. This week, the April numbers came out with inflation still running above 8% annually.
The Federal Reserve Board’s congressional mandate promotes balancing full employment and inflation. The six current members of the board have experienced only one side of that mandate – increasing employment. Over the past three months they have had to pivot toward price stability, and that’s not something the central bank has had to do for the last two decades plus.
So, they’re writing a new playbook on the fly. And the markets, both the stock and bond markets, are looking for some results before they give the central bank the benefit of the doubt that they have the right gameplan. Presently, the markets don’t have much confidence in the play calling.