Commonwealth

Following up on yesterday’s post about the recent market declines, I thought it would make sense to talk not just about the declines themselves (where they came from and where they are going), but also about what the declines mean from a larger portfolio perspective. To take the emotion out of it for a bit, and see what the larger picture can tell us.

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The economy seems to be doing well, with job growth still at high levels, consumer spending still healthy, and businesses continuing to invest. But the stock market—which is supposedly a barometer of that economy—is acting very differently. The market has fallen significantly from its peak at the start of the year and, more recently, has taken a sharper drop. What’s going on here, and will it continue?

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There were several housing-related economic data releases last week. The reports showed that the pace of new home construction continued to improve in March, driven by long builder backlogs and a lack of existing homes for sale. This will be another busy week of updates, with reports that will touch on business spending, consumer confidence, first-quarter GDP growth, and personal income and spending in March.

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Earlier this week, my colleague Rob Swanke wrote about the relevance of the 60/40 portfolio in light of the current market environment. He asked whether this investment model, which seeks to balance the growth potential of equities with the volatility mitigation potential of fixed income, should be abandoned. Spoiler alert! Rob suggests we need to look forward, not backward, when making portfolio decisions, even though market conditions have changed. While short-term adjustments may help boost performance, the 60/40 portfolio can still be an attractive choice for the moderately aggressive investor.

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Inflation has grabbed headlines for the better part of a year now, as the Covid-19 response led to increased demand and supply constraints. That said, short-term inflation expectations have changed dramatically in recent months. In April 2021, inflation expectations for 2022 remained relatively subdued, with the International Monetary Fund (IMF) calling for 1.6 percent consumer price inflation in 2021 and 1.7 percent in 2022 for advanced economies. In October 2021, these numbers had moved up to 2.8 percent and 2.3 percent, respectively. Since then, inflation in the U.S., euro area, and other advanced economies has continued to pick up, with the IMF’s most recent report from this month showing inflation for advanced economies at 5.7 percent in 2022 and 2.5 percent in 2023.

What has led to changes in this global inflation outlook? And what conditions are contributing to the IMF’s lowered inflation expectations going into 2023 and beyond?

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Over the past few years, many people have been looking for alternatives to the 60/40 portfolio (a portfolio allocation of 60 percent equities/40 percent fixed income)—and for good reason. The Fed’s massive intervention to lower interest rates made the 40 percent allocation to fixed income in the 60/40 portfolio much less attractive. With inflation reaching levels we haven’t seen in decades and the Fed set to push interest rates higher, people have been wondering whether fixed income still provides the protection of principal that many investors are looking for. The Bloomberg US Aggregate Bond Index’s worst quarter in more than two decades has certainly increased this concern. This pain, however, has put fixed income in a much healthier position going forward with higher starting yields able to cushion investors from further declines in price.

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