Stocks and bonds are ‘disaster discounting’ after worst run for investors in 20 years

Things can always get worse.

The S&P 500 SPX Index,
-1.51%
on Friday consolidated its worst monthly percentage decline since the March 2020 pandemic shutdowns, but also joined the Dow Jones Industrial Average DJIA,
-1.71%
and the Nasdaq COMP Composite Index,
-1.51%
in booking the worst 9-month tranche since 2002, according to Dow Jones Market Data.

“The problem is that at the end of last year, we were pricing in perfection and now we are pricing in disaster,” David Kelly, chief global strategist at JP Morgan Asset Management, said by phone.

“I don’t think any of us can remember a time for both stocks and bonds, probably since 2008, that has been as bad as this year.”

But with the carnage, Kelly and others also see an opportunity to recover battered stocks and bonds, without waiting for the market to bottom or for the Fed to end its fight against inflation.

Carnage: A Look at Costs

Stocks and bonds have been hit especially hard since Russia launched its war against Ukraine in February, or a month before the Federal Reserve began raising interest rates from near zero.

Government bond yields were -9.1% (see chart) six months after the Ukraine war, according to BofA Global, a steeper drop than the same time period for other wars in the last 70 years.

Bonds and stocks hit hard by the Russian war in Ukraine

BofA Global

From Russia intensification of the war against Ukraine has clearly fueled inflation around the world, spooked markets and exacerbated Europe’s energy crisis. A global flight to safer assets has also pushed up the US dollar higher still in september, DXY,
-0.07%
as concerns mount about the potential damage to emerging markets and US corporate earnings.

There’s also the US labor market, which looks unlikely to cool down when the August jobs report comes in next Friday. key economic data in the coming week for the Fed and the markets.

“Clearly a lot of the market weakness is due to the Federal Reserve,” James Ragan, director of wealth management research at DA Davidson & Co., said in a phone call. “They have made it very clear that they want the job market to go back a little bit. That’s really important.”

Ultimately though, bond yields have nearly doubled this year as the Federal Reserve sharply raised its benchmark interest rate to combat maximum of 40 years inflation. That dynamic has drawn investors to bargain hunting, while keeping them on alert for the next crisis that breaks out in the markets.

As a warning, a team of BofA Global credit strategists pointed to last week’s “slump in UK assets” and called the Bank of England emergency bond purchase response a warning to other central banks.

“The Fed has a tough choice: go slower from here or risk the BOE’s experience by having to repair the damage,” they warned in a weekly note to clients.

However, some investors also see opportunities in stocks and bonds down more than 10% to 25% (see chart) for the year, according to data from Mizuho Securities.

Stocks and bonds are sinking in 2022

Mizuho US Securities

The damage seems particularly severe when compared to the annual earnings of stocks, bonds, housing and commodities in a typical year for roughly the past five decades.

Bond and stock yields post gains in typical years since 1975

Mizuho Values

Corporate earnings estimates fade

While investors are concerned that the stock market slump could last a while, especially as earnings expectations fade, confidence has been growing among bond investors keeping an eye on today’s higher yields. .

US Investment Grade Corporate bond yields hit 5.7% this week, the highest level since 2009. The 10-year Treasury yield TMUBMUSD10Y,
3.828%
rose 3.8% on Friday, posting its biggest three-quarter yield gain since 1987, according to Dow Jones Market Data.

The bond moves come as corporate earnings growth estimates for the S&P 500 were lowered to 2.9% for the third quarter, year over year, according to FactSet data. That represents a sharp revision from the expected rate of 9.8% at the beginning of the quarter.

Against that backdrop, Ed Perks, CIO and senior portfolio manager at Franklin Income Fund, favors investment-grade corporate bonds that also fetch average dollar prices of $86, up from more than $110 about a year ago.

Individual investors often gain exposure to the sector through corporate bond exchange-traded funds, the largest of which is LQD,
-0.25%,
iShares iBoxx $ Investment Grade Corporate Bond ETF

“We believe that much of the damage has been done in this asset class, while in equities they are requalifying. She is rapidly changing in front of our eyes,” Perks said.

US stocks fell sharply on Friday to close out a terrible month, with the Dow Jones and S&P 500 ending the session down 1.7% and 1.5%, respectively, at their lowest levels since November 2020, according to Dow Jones MarketData. The Nasdaq posted a 1.5% drop and its lowest close since July 2020.

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