An anomaly occurred last week in markets. Bond and stock performance diverged rather dramatically. This divergence is strange market performance, often seen when investors perceive runaway inflation ahead. This article explains why this divergence may be an early sign that investors are beginning to suspect that inflation is out of control.
I track market performance weekly in terms of four key sectors (shown in the table below). Included in this table are results from July 26 (the day before the first of three Fed rate increases). This week a large divergence appeared between stocks and bonds (which typically move together):
Week Ended October 21, 2022
|ASSETS||7/26/2022||Last Week||This Week||Week||From 7/26|
Prior weekly results showed stocks and bonds mostly moving in the same direction. The divergence this week was serious with stocks going up over 5% and bonds dropping 5.5%.
Obvious questions arise:
- Is this divergence a sign that market expectations are changing?
- Is the divergence a fluke?
- What could explain such a divergence?
The questions and their answers are important for market participants.
Market expectations are always changing. Market analysts, especially those of the “talking-head” variety, explain all market moves (even though they are usually clueless). It is their job to appear knowledgeable and utter phrases like “the market got ahead of itself,” and “the selloff was too severe and investors took advantage of lower prices to buy.”
Some suggest that the Fed is now perceived as less serious than originally believed, causing the rise in stocks. If this were true, then bonds should have rallied as well. Surely bond investors and stock investors have similar IQs, information and assessment abilities.
Is it a Fluke?
It is possible the divergence was an unexplainable fluke. Subsequent weeks will answer this issue.
If it continues next week and beyond, it is likely that expectations are changing/have changed. Investors are not unsophisticated, at least in the sense that their expectations conflict to such a degree.
Why Such a Divergence?
Is there a rational reason stocks and bonds diverged so dramatically? One condition is consistent with such a divergence. It is rare, but important! That condition is when markets begin to fear runaway inflation. One week is too short a period to proclaim that this divergence is more than a fluke, but caution is in order.
Why would an expectation of runaway inflation lead to a divergence between stock and bond returns? If money is losing significant value (purchasing power), individuals will attempt to protect themselves from such losses. They will move away from fiat money sensitive investments.
A movement out of bonds and into stocks signals such expectations. Fixed-income investments are most vulnerable to inflation and less less desirable under these conditions. Bonds and savings accounts are especially vulnerable.
Hard assets like real estate, precious metals and collectibles (jewelry, upscale art, rare memorabilia, etc.) tend to rise in value in inflationary periods. Most Americans are not wealthy or knowledgeable enough to partake in such esoteric investments. However, those who own bonds understand they will be hurt more than stocks. As the move to leave bonds and enter stocks becomes widespread, a return divergence between the two asset classes occurs.
Classic inflation hedges like precious metals, land and collectables (jewelry, upscale art, rare artifacts, etc.) are ideal. Unfortunately, few investors are wealthy or knowledgeable enough to engage in these markets.
Expectation changes are typically slow in the beginning but can become “light-bulb” events. Wealthy individuals, likely more perceptive than average, cut back on financial assets by putting more funds into hard assets.
Others are late in recognizing what is happening. Of these, many lack the wealth and expertise to switch into hard assets. But once they understand what is happening, they move to protect themselves as best they can. For them, that involves fleeing fixed income assets.
Why Do Bonds and Stocks Diverge in Rapid Inflation?
Stocks are inadequate protection against runaway inflation, but they are better than fixed-income investments. Inflation generally raises corporate reported earnings, at least for a time. Stock prices increase to reflect these higher earnings. The protection stocks provide is neither full nor permanent.
Stocks are better than fixed-income investments which have no chance to inflate. But stocks are imperfect protection (even hard assets often fail to fully protect). Several years ago, Zimbabwe experienced horrific hyperinflation. During this inflation, the Zimbabwe stock market was the best performing (in nominal terms) market in the world. Fixed income asset values moved toward zero. In the end, hyperinflation destroyed everything. Zimbabwe’s stock market did not escape the destruction. A very poor country became poorer.
Inflation drives stock prices higher, although not necessarily high enough to cover the losses in purchasing power. Inflation drives fixed-income investments lower because of fixed dollar-denominated contracts.
In a runaway inflation, holding stocks is less harmful than holding fixed income securities. Doing so may mitigate the pain temporarily, but inflation eventually destroys everything!
Keep your eyes open to the performance of stocks and bonds. If similar divergences continue, we are all in trouble!