Math hints on bonds, balance, recession
By Kyle Tetting
Real gross domestic product in the United States decreased at an annual rate of 1.6% in the first quarter of 2022. The decline was on the heels of six consecutive quarters of strong economic growth, a clear sign that a post-pandemic resurgence is waning. The data so far suggests the ebbs and flows of a normal market cycle, with a current emphasis on the ebb, but even Fed Chair Jerome Powell has acknowledged a recession is “certainly a possibility.”
While I believe a focus on current economic conditions may be shortsighted, it’s worth understanding just where we stand. There’s always a danger in saying “this time it’s different,” but nuance is critical to understanding just what matters as we plan for what comes next.
First, and foremost for me, interest rates have suddenly made bonds more attractive.
For the 10 years ended May 31, 2022, the average intermediate-term core bond fund posted an annualized return of 1.66%, according to data from Morningstar. Over that same period, the S&P 500 posted an annualized return of 14.4%.
Back-of-the-napkin math tells us that a portfolio that was 50% stocks and 50% bonds returned roughly 8% in those 10 years, but 90% of the return would have come from stocks. In other words, 50% of the portfolio contributed 90% of the return.
Ten years ago, a 7-year U.S. Treasury — a good proxy for the return potential of intermediate-term bonds — yielded less than 1.25%. Now, that yield sits north of 3%, suggesting a far higher potential return for bonds.
When bonds contribute more, we need stocks to do less of the heavy lifting. We can take some risk off the table and still reach our longer-term objectives. As a result, when we hit periods of market volatility, as we have lately, our portfolio is better insulated from the risk.
In addition to the math working out better for lower volatility assets like high-quality bonds, current economic data points to some additional mitigation of the risks of recession.
A notable concern in recession is job loss. As U.S. workers lose their jobs, they’re less able to afford purchases. However, as of the end of April, 11.4 million jobs remained open. Though many of those jobs may be unfulfilling, pay minimum wage or carry some other blemish, U.S. employers have far more work than workers, a sign that laid-off workers may not need to stay unemployed for long.
Also, Americans broadly are in strong financial shape. Both households and businesses are flush with cash, with U.S. households sitting on more than $4 trillion in readily accessible deposits and currency. Not only may employment be less of a problem, but with cash to spend, households may be more insulated even if unemployment rises.
To be clear, even mild recessions are painful. Those piles of cash aren’t distributed evenly, and job loss never looks the same from industry to industry or region to region. Nevertheless, the current data points to an economy entering any potential recession with a stronger foundation than the recessions of recent memory.
Finally, stocks entered bear market territory in June. While a variety of factors have played into the market’s decline, expectations for slowing economic growth have certainly played a role. As a leading indicator, stocks reflect expectations rather than response to yesterday’s data. That isn’t to say the risk of recession is fully priced into the stock market, but I think it’s fair to say slow or no growth won’t surprise too many investors.
All of this leaves me with hope that even if recession is more than “certainly a possibility,” there is a clear path we can follow to navigate the risks. We must match our exposures to our time horizons, holding cash for immediate needs, bonds and other lower volatility investments for needs a bit further out and stocks for the prospects of long-term growth beyond the current cycle.
The right balance is necessarily specific to the individual, but balance remains the key.
War in Ukraine reminds us of role for bonds, by Kyle Tetting
When Should I …rebalance my portfolio? by Art Rothschild
How bonds fared as Fed has raised rates, a 2016 Money Talk Video with Kyle Tetting
The importance of balance, a Money Talk Video
Recessions: Uncertainty suggests balance, a Money Talk Video with Kyle Tetting
How to handle fears of recession, a Money Talk Video with Bob Landaas and Kyle Tetting
(initially posted June 30, 2022)