Let’s face it. Being an investor in the markets hasn't been an enjoyable ride so far this year. Global stock market indices are down after some particularly volatile trading sessions over the past weeks, with certain sectors—such as technology—falling off their highs by more than 20%.

Adding to the discomfort, bond markets have also posted double-digit declines, meaning those invested in diversified stock and bond portfolios are also feeling the pain. Viewed as safer investments, bonds typically provide a buffer against stock market declines. Unfortunately, the two have been moving down together, an uncommon occurrence from a historical perspective.

Let’s examine some general themes that have contributed to the market environment that we find ourselves in and then explore what the future may hold for investors.

What’s been happening?

The pandemic changed our lives, altering our spending and saving habits. Social restrictions limited travel and contributed to global supply chain disruptions as manufacturing plants shut down. They also led to households shifting discretionary purchasing habits from the service sector, such as travel and entertainment, to the purchase of tangible goods, such as bicycles or home gym equipment. Furthermore, governments and central banks stepped in to support consumers and businesses by providing financial aid and very low borrowing rates. These stimulus measures led to an increased amount of savings for the average consumer. 

The change in spending habits away from services towards goods, coupled with higher savings levels, led to a strong increase in demand. Combined with less inventory arising from supply chain disruptions, prices for goods increased, or said another way, inflation rose. 

Since labour markets and economies remain strong, central banks including the Bank of Canada and the United States Federal Reserve have begun to aggressively increase rates in an attempt to curb demand and reign in inflation. That said, the war in Ukraine and China’s stiff lock-down measures to limit viral spread continue to cause supply chain disruptions and rising commodity prices (such as energy), which remain major headwinds to achieving lower inflation.

How has this impacted bond markets?

Bonds generally have an inverse relationship with interest rates. When rates (or future rate expectations) increase, the bond prices generally fall. As inflation continues unabated and central banks become increasingly hawkish (a more aggressive policy tone on inflation, generally leading to interest rate increases), the bond market prices in these higher (but expected) interest rate changes, ultimately leading to lower bond prices. 

The good news is that much of the pain for bondholders may have already been realized and that bond yields, or the expected future returns, are now much higher and attractive. In the shorter term, bonds may fall further if inflation expectations worsen and further expectations for rate increases materialize beyond those currently anticipated. 

Conversely, should inflation begin to cool as a result of central bank policy or supply chain issues naturally resolving, the amount of rate increases may reduce, which could lead to a rebound in bond prices. In any event, investors will earn a higher yield to hold bonds, which strongly correlates to their expected returns over the medium- to long-term.

How has this impacted stock markets?

Stock performance in most markets have been pummeled by a number of factors so far this year including inflationary fears, rising rates and uncertainty surrounding the Russian invasion of Ukraine.

Rising inflation affects the stock market in a couple of ways. Firstly, rising input costs such as energy, wages, and other raw materials, increase a company’s production costs for their goods or services. Unless companies increase their prices, they may suffer declining profits. Secondly, central banks have begun increasing rates in response to high inflation, which is meant to reduce demand for goods and services. This may also lead to a decrease in business revenues and earnings. As inflation remains high and continues to rise, there are increasing concerns that central banks will be required to raise rates to a point that may ultimately lead to a recession. 

Adding to the fears, is the general uncertainty about the war in the Ukraine, which has contributed to continued inflationary pressures with rising commodity prices. Additionally, the lock-down measures enforced in China in order to limit the spread of COVID-19 have market participants considering the implications on global supply chains and the growth prospects of the world's second largest economy. 

The good news is that many companies and sectors within the stock market are fairly well positioned to handle higher inflation and rising rates. Many companies—especially those with unique products and services—have the ability to adjust their prices and pass their price increases along to the consumer, protecting their margins and revenues. Additionally, earnings and expected earnings have generally remained strong this year as the economy continues to show strength with low unemployment and strong consumer spending. 

Cyclical sectors have even performed well including energy and materials, which have benefited from higher commodity prices. As such, the Canadian market, as represented by the S&P/TSX Composite has fared relatively well due to its high exposure to the energy and materials sector. Though many sectors have seen declines, the most heavily impacted include those that previously benefited from the “stay-at-home” restrictions and low interest rates, such as growth companies in the technology sector. This stark contrast is apparent in looking at the technology-heavy US market as represented by the S&P 500, or even more specifically, the NASDAQ, which are significantly off their highs. 

Final thoughts

There is no doubt that investors have been through a painful ride so far this year as bond prices fell in tandem with stocks. Despite legitimate concerns regarding inflation, rising rates and geopolitical uncertainties including the war in Ukraine, some positive indications persist. The overall economy remains strong with low unemployment and high consumer spending, and a recession over the near-term is unlikely. In addition, inflation will eventually fall in response to rising rates and supply chain issues working themselves out. In fact, the most recent inflation figures from the US—although high—are lower than they were in the previous month, suggesting that perhaps inflation has finally peaked.

Unfortunately, we cannot accurately forecast what will happen in the short term as uncertainty and volatility remain an inescapable reality of investing in the markets. What we may choose to focus on instead is the fact that markets have historically bounced back from even the most negative of circumstances, continuing on to rise and reward patient investors.