Friday, December 9, 2022
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Stock and Bond Correlation

During the pandemic, liquidity flooded the economy. Monetary policy, which is the Federal Reserve’s purview, left interest rates at zero. This permitted businesses and consumers to lend or borrow at low rates. It was incredibly inexpensive to buy a car, buy a house or issue corporate bonds with low interest rate loans. 

Fiscal policy, which is government spending and the utilization of tax policies to influence economic conditions, was excessive to help citizens and businesses that were unable to work or remain open due to lockdowns or illness. $5.2 trillion was funneled into the economy to avoid collapse. The assistance included public health measures, expansion of unemployment insurance, federal aid to state and local governments and direct payments to individuals and families. 

In the Federal Reserve notes this year, the Fed cited the role extensive fiscal stimulus throughout the world contributed in leading to increased inflation pressure. With plenty of cash but no access to usual services and travel, people spent money on goods. Inflation can be a symptom of supply and demand when too few goods (cars, furniture, semiconductors, etc.) are being chased by too much easy money.

Fiscal stimulus has slowed, with only the threat of school loan forgiveness currently in play. The University of Pennsylvania’s Wharton School of Business estimates the debt cancellation will cost up to $519 billion. This means recipients will have more monthly discretionary income from not paying the loan debt. 

The average inflation rate in the United States since 1914 is 3.29% and the October inflation rate was 7.7% year over year, down from a high in June of 9.1%. The Federal Reserve initially assumed the inflation was transitory. It was caused by the reopening of the economy while people had cash reserves and pent-up demand because supply chains were disrupted. However, inflation remained stubbornly high. The Federal Reserve took action and is raising interest rates steadily and in large percentage points. 

The adage “don’t fight the Fed” held true in 2022. The Federal Reserve raised interest rates to dampen economic growth in March 2022. They started with a small move of 25 basis points, or a .25% increase. This took the range for federal funds to .25%-.50%, essentially leaving zero interest rates for the first time since the beginning of 2020. The stock market, which is forward looking, hit its peak in January 2022. 

For people invested, this year has been an incredibly difficult downturn. Each quarter brought lower lows in the stock market. In most market downturns in our lifetime, bonds or fixed income created a safety net. That is why investors often use an allocation of 60/40 with 60% held in stocks and 40% held in bonds in an investment portfolio. For instance, in 2008 during the Great Recession, the S&P 500 (a U.S. stock index) fell 38.49%, while Bloomberg Barclays U.S. Aggregate Bond Index returned a positive 5.24%. Year-to-date 2022, (as of Sept. 30), the S&P was down 23.87% while the Bloomberg Aggregate Index was down 14.61%. Stocks and bonds have not correlated to the downside together like this for over 40 years. Stocks are looking at the economy and bonds are looking at inflation and the Fed raising interest rates. Rising interest rates hurt existing bonds due to their interest payments being lower than newly issued bonds at these higher interest rates.

With inflation still at high levels but softening slightly and revenue coming in better than anticipated, stocks have moved up 11.33% since October. The S&P U.S. Aggregate Bond Index rose .85% since Oct. 1. The data is as of Nov. 16. Recoveries in the markets come at unexpected times and tend to surprise investors; that’s why staying the course and keeping to your allocation makes sense for future success.

All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice.  Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.

Judy Loy is a Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc. in State College.