Bonds Are Back

Here are some of the biggest stories from last week:

• Inflation in the UK rose by less than expected.
• And the country’s economy continued to grow at a solid pace.
• US inflation fell to its lowest level in over three years.
• Institutional investors bought the dip during last week’s market meltdown.
• Bonds are regaining their role as a portfolio hedge after years of letting investors down.

Dig deeper into these stories in this week’s review.

Macro

New data this week showed UK inflation rose by less than economists and the Bank of England had expected last month. Britain’s annual inflation rate increased from 2% in June to 2.2% in July, while core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, fell from 3.5% to 3.3% – its lowest level since September 2021. Adding to the good news, services inflation – a measure closely watched by the BoE for signs of domestic price pressures – cooled to 5.2%, the smallest reading in more than two years and below the 5.5% economists were forecasting. The better-than-expected report prompted traders to increase their bets that the BoE will continue to lower interest rates this year, following its first rate cut since the pandemic earlier this month.

Separate data a day later showed the country continued its solid recovery from last year’s recession. The UK economy grew by 0.6% last quarter from the one before, following a 0.7% gain in the first three months of the year. The figure was in line with economists’ expectations and reflected strength in government spending and the services sector, both of which helped offset small dips in the production and construction sectors. Investors are now hoping the second half of 2024 will be strong too, given that real (i.e. inflation-adjusted) wages are growing and the BoE has started to cut interest rates. But still, the new government has a long way to go if it wants to fulfill its lofty pledge to boost UK growth to 2.5%, given the economy has spluttered at a lackluster pace in recent years.

Investors across the pond also got some good news this week, with new data showing US inflation unexpectedly cooling in July. Annual inflation ticked down slightly to 2.9% in July, defying economist predictions for a flat reading. It also marked the first time the rate has fallen below 3% since March 2021, when inflation first took off in the US. What’s more, core inflation decelerated for the fourth consecutive month to 3.2% – its lowest level in over three years. On a month-over-month basis, both headline and core consumer prices increased by 0.2%, in line with forecasts.

The report confirmed that inflation is still on a downward trend as the US economy gradually slows. Combined with a softening job market, the Fed is widely expected to start lowering interest rates next month, while the size of the move will likely be determined by more incoming data. Futures are currently pricing in a full percentage point of rate cuts by year-end. With only three Fed meetings remaining, this implies that one of them will need to see the central bank reducing rates by half a percentage point.

Stocks

As global markets went into freefall at the start of the month, hedge funds and other institutional investors seized the opportunity to buy the dip – a tactic usually reserved for the retail crowd, who, in sharp contrast, sold aggressively amid the panic. And if history is anything to go by, these big-money investors might just be onto something.

According to Goldman Sachs, long-short equity hedge funds snapped up individual US stocks at the fastest pace since March last Monday (August 5th), reversing a months-long selling spree. That was confirmed by separate data from JPMorgan, which showed institutional investors bought a net $14 billion worth of shares that day – significantly higher than the 12-month average. Retail investors, on the other hand, dumped $1.4 billion worth of individual stocks.

While it’s hard to generalize institutional investors’ thinking, it’s reasonable to assume that they probably viewed the sell-off as a short-term, sentiment-driven overreaction rather than a long-term issue with stock fundamentals or the broader US economy. And although it’s still early days, the S&P 500’s sharp rebound from the intraday low it hit on August 5th is already vindicating their decision to buy the dip.

In fact, if history is any guide, the recent pullback does spell opportunity. Since 1980, the S&P 500 has generated a median return of 6% in the three months that followed a 5% decline from a recent high, with the index delivering a positive return in 84% of the episodes, according to Goldman. However, an important caveat applies: just because a certain dip-buying strategy has worked in the past, it doesn’t necessarily mean that it’s guaranteed to work in the future.

Bonds

Investors have always generally assumed that stocks and bonds are inversely correlated – that is, when the price of one falls, the other rises. But that age-old relationship had been thrown in doubt in recent years, especially in 2022, when aggressive interest rate hikes caused both markets to crater at the same time. In fact, the 60/40 portfolio, famed for its time-tested ratio of 60% US stocks and 40% US bonds, lost 17% that year – its worst performance since the global financial crisis in 2008.

But bonds have finally reestablished themselves as a reliable portfolio hedge, as evidenced by this month's market turmoil. As the S&P 500 lost about 6% during the first three trading days of August, the US Treasury market posted gains of almost 2%. That left 60/40 investors with a reason to feel smug as their portfolios outshined those fully invested in stocks. One reason bonds are starting to shine again is the shifting economic environment. With inflation more in check, the focus is turning to a potential recession in the world’s biggest economy. In fact, one of the drivers behind last week’s market rout was July’s US labor market report, which triggered an eerily accurate recession signal called the “Sahm Rule”. As a result, expectations for interest rate cuts have mounted fast, and bonds do very well in that environment.

Reflecting that positive outlook, investors have poured $8.9 billion into US government and corporate bond funds so far in August. That comes after inflows of $57.4 billion in July, which marked the highest monthly figure since January and the second-biggest since mid-2021, according to EPFR. High-grade corporate debt has seen 10 weeks of positive flows – the longest streak in four years. But despite that, some investors remain nervous about the potential impact of an economic slowdown on corporate profitability and, in turn, corporate bonds.

Next week

• Monday: Earnings: Estee Lauder, Palo Alto Networks.
• Tuesday: China one-year loan prime rate announcement. Earnings: Medtronic.
• Wednesday: Japan trade balance (July), minutes of the Fed’s latest meeting. Earnings: Zoom.
• Thursday: Eurozone, US, and UK PMIs (August), minutes of the ECB’s latest meeting, eurozone consumer confidence (August). Earnings: Baidu, Intuit.
• Friday: Japan inflation (July), UK consumer confidence (August).