For investors looking for security, bonds have long been a popular option, especially during volatile market conditions. But as we saw last year, bonds can also experience bear markets, just like equities do. Today, let's think back to one of the most notable inflation-driven bond bear markets ever, explore what happened, and draw lessons that can inform our future tactics.
The 1970s: A Decade of Stagflation
The 1970s are remembered for “stagflation” - a combination of stagnant economic growth, high unemployment, and runaway inflation. While many factors contributed to this scenario, the oil price shocks of 1973 and 1979 played important roles in leading to inflationary pressures (sound familiar?).
During this time, the United States experienced one of its most severe bond bear markets. Bond yields rose in tandem with inflation to compensate investors for the declining purchasing power of their fixed interest payments. The 10-year Treasury yield, for example, began the decade around 7.8% and ended near a whopping 12.5% in 1979, eventually peaking above 15% in 1981.
After the Storm: Bond Market Recovery
So, how did bonds fare once this tumultuous period subsided?
By the early 1980s, aggressive monetary policies, particularly those of Federal Reserve Chairman Paul Volcker, had begun to bring inflation under control. The key strategy involved a significant increase in federal funds rates, which caused a short-term economic squeeze but eventually reduced inflationary pressures.
Bond yields began a multi-decade decline as inflation was tamed and eventually reduced. The decline in yields (or rising bond prices) signaled the start of a long bond bull market that would last well into the twenty-first century. Investors who entered the bond market when yields were at their peak in the early 1980s earned handsome returns over the next few decades.
Takeaways for Today's Advisors
While history doesn't repeat itself verbatim, it often rhymes. Here are some insights for modern investment advisors:
Be Cognizant of External Shocks: External shocks, like oil price surges in the 1970s and 2022, can significantly affect inflation and, by extension, bond markets.
Monetary Policy is Critical: For better or worse, central banks, particularly the Federal Reserve, play an important role in influencing bond markets through their control of short-term interest rates and signaling.
Long-Term Outlook: While bonds faced a difficult environment in the 1970s, the subsequent decades highlighted their importance in a diversified portfolio.
Stay Informed and Diversify: Keep an eye out for emerging trends, diversify portfolios, and make sure your strategies can adapt to both inflationary and deflationary scenarios. Use the iQ Portfolio Optimizer to build diversified portfolios based on historical correlations.
As we have seen, bonds have their own set of risks even though they are frequently thought of as safe havens. Investment advisors can better navigate these complexities and keep offering value to their clients by comprehending previous cycles and maintaining a proactive strategy based on historical testing.