Prevailing view or misconception?

Pendal’s Amy Xie Patrick busts a few modern investing myths

Over the past few years, conventional market assumptions have been upended. Inverted yield curves, often thought to signal recessions, no longer guarantee an imminent downturn. Similarly, expensive valuations can continue to rise, and rate hikes don’t always result in economic contraction. Bonds, traditionally seen as defensive, are increasingly relevant due to their ability to respond to inflation and growth cycles.

As the economy shows signs of cooling inflation and slowing growth, bonds now present a solid investment opportunity, offering both income and potential for capital appreciation.

The relationship between bonds and equities has also shifted. While bonds typically rally at the start of recessions, they are not merely reactive to equity market movements. Instead, their performance hinges on broader economic factors like inflation trends, growth trajectories, and central bank policies. During the Global Financial Crisis (GFC), central banks often cut interest rates, boosting bond prices. This negative correlation between bonds and equities became ingrained in financial thinking, leading many to see bonds as a “servant asset class” to equities. However, the fundamentals that drive bond markets – especially inflation – remain crucial.

Recent rate hikes were expected to trigger a recession, but fiscal stimulus in many parts of the world, particularly in the U.S., softened their impact. This stimulus put cash into consumers’ pockets, dampening the effects of higher borrowing costs. However, as this liquidity fades and inflation slows, bonds are likely to benefit. For the next economic cycle to begin, interest rates will need to fall, making borrowing more affordable and driving the next wave of spending.

Looking ahead, bonds are set to perform well due to improving economic conditions. Inflation in major economies is nearing central bank targets, reducing the need for further rate hikes. At the same time, growth is softening without collapsing. The disinflationary trend, combined with weaker growth, supports the case for bonds. Political factors may add volatility to bond markets, but the overarching cycle will dictate their performance.

Despite two wars in oil-heavy regions, oil prices have struggled to rally, suggesting softer demand. Meanwhile, countries like Europe and China are grappling with economic challenges. Europe’s near-recession status and China’s post-crisis difficulties contrast with the fiscal boosts experienced elsewhere. The pandemic-related stimulus that once bolstered markets is dwindling, and U.S. fiscal policy alone won’t replenish that liquidity. While rate cuts could ease some of the pressure, they’re unlikely to offset rising borrowing costs as older loans reset.

Ultimately, what benefits bonds may not always benefit equities. While lower inflation supports both asset classes, weaker growth primarily benefits bonds. Investors may be pricing in a soft landing, but if growth falters more sharply, equities could struggle. Bonds, however, are positioned to thrive, especially if inflation continues to recede.

At this point in the economic cycle, owning bonds makes sense. They offer positive income and the potential for capital gains as inflation declines. While there’s always the risk of another inflationary shock, the current trend suggests that bonds will remain a valuable component of investment portfolios.