Bonds were the clear loser in the first quarter as nearly every investment class showed impressive gains, with the exception of fixed income.
All parts of fixed income underperformed stocks, with losses in municipals, corporate and treasury indicies ranging from 1% to well over 12% for the quarter.
The cause of this? Interest rates have begun to rise, even though from a historical perspective they are still relatively low. Late last summer we discussed the risk in long-term fixed income investments, as interest rates in the U.S. were approaching negative territory, a phenomenon that many countries around the globe had already experienced.
At the time, 10- year U.S. Treasuries were testing 51 bps., or just over ½ of 1%. Today the 10 year has surged 3.2x as it has surpassed 1.75% – all in a matter of 8 months. On the stock front, vaccines and cheap money, combined with more stimulus than expected, has provided euphoria into the re-opening. While the U.S. is doing better than many of its European counterparts, the growing drumbeat of strong pent-up demand, especially for travel and entertainment, has pushed stocks to all-time highs.
It has been an interesting quarter where the laggards of the prior years – like energy, financials, industrials, and materials – have led the way, and former leaders – like technology – took a pause. We expect such divergence to continue, but the swing from growth to cyclicals is likely to decelerate from the pace we have seen in the past two quarters. Just as we expected interest rates to move meaningfully higher from their historic lows last summer, we expect to see higher tax rates on corporate, estate, and individual incomes as well as capital gains by this time next year. Simply put, the U.S. government will ultimately need to pay for all this stimulus.
This is likely to offset some of the positives we mentioned earlier. In addition, investors should also keep an eye on inflation, already seen in many commodities over the past year or two with food, energy and, more recently, labor costs starting to trend higher. Below is a chart that illustrates the trend of higher interest rates and the resulting underperformance in bonds.
We continue to feel that fixed income, particularly longer-term maturities, have the opposite features you want in an investment. They offer little reward with interest rates still low, along with elevated risk.