The stock market has been a little unsteady the past few weeks as it tries to digest the recent rise in interest rates. While rate increases were highly anticipated, a potential change in sentiment could be part of the reason equities continue in their struggle to stabilize in this environment.
Part of the uncertainty is in response to inflation over the last six months. Year-over-year change to Core CPI is up from 1.8% to 2.1% as of March 2018. While inflation was expected to increase, sentiment is starting to shift towards fear of inflation increasing too quickly. For quite some time, inflation has failed to show up, with a far greater risk of deflation dominating the last decade. However, with large spending deficits coming late in the economic cycle, low unemployment leading to wage pressure and increased price targets from the Middle East on oil among other issues; inflation expectations are rising.
What is difficult in a time of inflation expectations increasing is that both the stock market and bond market can struggle in the short-term. This is hard as many investors have become used to the two markets being mostly negatively correlated over the last several years. For those who wanted to reduce their equity risk, the answer has been to simply add more bonds and the results were fairly instantaneous. With the relationship between stocks and bonds evolving in this changing economic environment, it is easy to understand why the markets have felt a bit shaky.
The good news is that in many ways, none of this is necessarily unexpected. During the 1970’s when inflation was difficult to keep in check, stocks and bonds also showed a more positive relationship. However, as the Federal Reserve evolved its ability to keep inflation in check, the relationship reverted to negative to the present day. While inflation expectations are increasing because of some surprises, at least at this point, the markets have not lost confidence in the Federal Reserve being able to keep inflation in check.
So what do we do for now? Asset allocation remains a pillar of portfolio construction. No matter what short-term correlations may be, high-quality bonds are still strong performers in nearly ever recession. Their role in protecting the portfolio remains intact. As rates increase, so do the return expectations for bonds over longer-term horizon. Be wary of stretching for returns in this type of environment. The temptation to reach for higher-yielding investments such as REITs and MLPs carries far too much risk of volatility and does not offer any of the protection of a high-quality portfolio of bonds. Patience is key in late cycle markets. It is best to wait for better valuations to ensure quality returns over time.