(Bloomberg) — An exciting Friday rally saved the week for tech investors, but failed to undo the damage to the broader market amid increasingly harsh signals about the economy, many of which came from bonds.
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The S&P 500’s 2023 rise, spurred by speculation that inflation is cooling, began to show cracks in the four-day week as focus shifted to the prospects of an economic contraction. Fears that the Federal Reserve’s campaign of rate hikes has gone too far are looming large in the Treasury market, where the three-month shedding of riskier assets reflects growing bets on a slowdown.
It’s not just the gloomy economic signal from fixed income. Despite the rally at the start of the year, government bonds remain a legitimate competitor to equities in terms of valuation. A rough comparison of returns suggests that there is room for recovery in government bond prices, given a still expensive equity market.
All of that wasn’t enough to prevent Friday’s tech-led rally, the biggest gain of the year for the Nasdaq Composite Index. The S&P 500 still suffered its first weekly decline of 2023, held back by losses on Wednesday and Thursday after reports on retail sales, producer prices and business equipment reignited concerns about the future of the economy.
“We believe that the S&P in particular is trading at valuations that are inconsistent with what we are likely to see in earnings,” David Spika, president and chief investment officer of GuideStone Capital Management, said in an interview. “Bonds are still expensive, but relative to equities they are much more attractively valued.”
The $32B iShares 20+ Year Treasury Bond exchange-traded fund (ticker TLT) is up 6.7% in 2023 as investors seek safety in long-dated government securities, versus a 3.5% rise for the $365B SPDR S&P 500 ETF Trust (SPY). That sets TLT up for a third straight month of outperformance against SPY, its longest winning streak since 2020.
According to Nicholas Colas, co-founder of DataTrek, the long-dated bond ETF has just recorded a 50-day gain that surpassed 12.5% — something that historically only occurred when a recession was imminent or fear was high. Research. Over the past two decades, such a rise has occurred in 2008-2009 and also in 2020, when the recession was just around the corner; it happened from 2010-2012, in 2015 and in 2019, when investors worried about one, he found.
“Seeing a +20-year rally by this amount is therefore not a foolproof recession indicator, but it does indicate that markets are concerned about an economic contraction,” he wrote in a note.
The S&P 500 fell 0.7% in four days, dragging its gains to 3.5% this year.
Even after the historic sell-off in 2022, the so-called Fed model — which plots the S&P 500 earnings yield versus 10-year Treasury yields — shows that bonds are still cheap relative to stocks, at least according to recent history. Relative to its price, the S&P 500 “pays out” about 5.2% in income versus about 3.5% on the US benchmark bond. That’s nearly the smallest gain for stocks in the past decade.
“Yields could fall even further, despite falling quite a bit in recent days, and it’s an environment where bonds are cheap again,” said Meera Pandit, JPMorgan Asset Management’s global market strategist. on Bloomberg television. “The attractiveness of bonds going into the remainder of 2023 has increased tremendously.”
Those early returns have breathed new life into the decades-old 60/40 investing approach after last year’s double sell-off in stocks and bonds produced the strategy’s biggest annual loss since the 2008 financial crisis. Portfolios split between 60% stocks and 40% bonds are having their best start to a year since 1987, according to a Bloomberg Index.
The debt market’s dominance so far against still-expensive equities has led some portfolio managers to advocate a twist on the classic strategy: swap the components and invest the majority of assets in bonds.
“The bond market is arguably cheap for the stock market,” DoubleLine Capital’s Jeffrey Gundlach said during a recent webcast hosted by his firm. “I don’t recommend a 60/40 portfolio, but more of a 40/60 portfolio, or even a 60/25/15 portfolio – bonds, stocks and then other things in the 15%.”
–With help from Lu Wang.
(An earlier version of this story corrected the bond allocation in the last paragraph.)
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