When stocks and bonds retreat in sync, review your strategies

Luis Alvarado,
Investment Strategy Analyst,
Wells Fargo Investment Institute

In my mind, there’s nothing quite like a day at the beach. Fortunately for me, during my youth in Costa Rica, my time in Los Angeles, and now here in San Francisco, there’s been a beach nearby. Along with days in the sun, I have, of course, experienced the disappointment of dashed expectations when thunderstorms rolled in and upset the day’s plans.

Investors who’ve diversified their investments to include both stocks and bonds must be feeling a similar emotion when they look at their portfolios’ performance. And why not? It takes time and effort to build a diversified portfolio with the idea that when stocks zig, bonds will zag and this will typically help smooth out overall performance. And now after all that, you have a period like 2022 when both asset classes declined. Hence, you may have investors feeling like it’s a rainy day at the beach.

During this period of rising interest rates and persistent inflation, let’s take a look at past periods when stock and bond prices retreated concurrently for potential insights and discuss implications for investors.

What does history tell us?

It appears this unusual period took many investors by surprise. Typically, during stock market sell-offs, investors have tended to move to bonds as a perceived “safe haven” asset, driving bond prices higher and yields lower. However, during 2022, this trend was broken, leading some investors to rethink the value of owning bonds as a potential portfolio stabilizer.

Historically, our research shows a combination of equities and fixed income has, as a general rule, enhanced diversification benefits for a portfolio. Bond prices typically have been more stable than equity prices;¹ this relative stability has often helped insulate a portfolio during times of market stress and smoothed out performance over time.

For a closer look, we at Wells Fargo Investment Institute used the Ibbotson Associates Stocks, Bonds, Bills, and Inflation (IA SBBI) U.S. Long-Term Government Bond Index and the IA SBBI U.S. Large Stock Index as proxies and found only six calendar years since 1929 in which both stocks and bonds declined on an annual basis: 1931, 1946, 1969, 1973, 1977, and 2018. Based on these results, you might think that stocks and bonds have declined in lockstep:

• During periods of extreme economic hardship (like the 1931 Great Depression)
• When there’s been abrupt increases in inflation (like in 1946 and 1977)
• In run-ups to an economic recession (like in 1969 and 1973)
• During Federal Reserve (Fed) tightening cycles (like in 2018)

But drawing conclusions based on such a small sample size can be misleading; performance figures differ if you use a different index to measure returns. Many fixed-income investors today hold portfolios with a diverse mix of bonds beyond long-term U.S. government securities. With that in mind, we used the Bloomberg U.S. Aggregate Bond Index since its inception in 1976 as a proxy and found only four calendar years with annual negative returns: 1994, 1999, 2013, and 2021. Yet, none of these years coincided with negative returns for U.S. equities on a total return (market price movement plus dividends) basis.

In our view, both U.S. equity and fixed-income markets have experienced significant declines this year largely due to persistent levels of inflation and a fragile post-pandemic economy aggravated by an aggressive Fed tightening policy coming out of the extended period of all-time low interest rates. We expect this trend to continue in the near term.

Investment implications

Much of the time, investing with the expectation that bonds will zig when stocks zag has been key to successful asset allocation. However, 2022 was not one of those times, and it’s difficult to predict how long these rainy days will continue. We believe several macro trends contributed to what happened, including rising yields, elevated inflation, a slowing economy, supply-chain disruptions, the war in Ukraine, and lockdowns in China.

Stocks and bonds may continue to underperform if economic growth contracts in the first half of 2023 as we expect. We believe having a diversified portfolio that includes exposure to commodities that we expect to rise with inflation and, for qualified investors, alternative investment strategies with low correlations to stocks and bonds, like Relative Value and Macro, can help hedge against losses and may help insulate portfolios from additional market price volatility.

Rather than abandoning your asset allocation, I encourage you to reach out to your investment professional for questions about how to position your portfolio in today’s unusual market environment.

1. Standard deviation is a frequently used measure of market volatility — the higher the standard deviation, the greater the volatility. From 2007 to 2021, for example, the average standard deviation for investment-grade fixed income as measured by the Bloomberg U.S. Aggregate Bond Index was 3.2%. For U.S. large-capitalization stocks as measured by the S&P 500 Index, the average standard deviation was 15.3%. The Bloomberg U.S. Aggregate Bond Index is composed of the Bloomberg U.S. Government /Credit Index and the Bloomberg U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities. The S&P 500 Index is a market-capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. Sources: Wells Fargo Investment Institute, ©Morningstar Direct. Hypothetical and past performance do not guarantee future results. An index is unmanaged and not available for direct investment.