Bond performance, inflation, and the impact on low-risk portfolios

At a glance:

• Higher interest rates, and changing expectations around when they may be cut, have negatively impacted bond market returns in recent years. 
• Lower-risk portfolios, which by their nature have more exposure to bonds, have underperformed in this environment.
• Inflation has fallen significantly since peaking in 2022, though central banks remain cautious in their fight against persistent price rises. 
• As central banks begin to bring interest rates down, the outlook should be more positive for fixed income capital returns.
• For multi-asset portfolios, the hope is for the return of a negative correlation between equity and bond markets.

Nutmeg offers a range of portfolio risk levels, including lower-risk portfolios that have more exposure to fixed income (or bonds). Bonds are a 'defensive' asset class which is historically less volatile than 'risk' assets like equities.

Unfortunately, fixed income has gone through a tough time in recent years. Global bonds delivered negative returns of almost 1% in the year to May 2024, in pound sterling terms. While this is an improvement on the 7.8% fall in 2022, it's still a negative return that is very unwelcome.

We explore what's going on, and what Nutmeg clients can expect from the bond market going forward.

What's behind this year's bond market losses?

There are several factors, but the most central is changing expectations of central bank rate cuts.

As discussed in our recent article, Inflation, interest rates, and investing, fixed income assets don't like inflation. 

Firstly, this is because inflation eats away at the fixed coupon returns - the interest rates set at the time a bond is issued. Secondly, because it causes central banks to raise interest rates. Bond valuations tend to fall when this occurs unexpectedly, and don't tend to rise again until rates come down. 

In recent years, we have seen interest rates rise globally to combat the impact of a period of high inflation. While inflation has eased somewhat from its peak in late 2022, markets expected more interest rate cuts than what has materialised.

If we look back to the end 2023, UK bond markets expected the Bank of England to deliver six or more rate cuts (each one quarter of one percent) in 2024, as inflation plummeted from over 10% in late 2022 to 4% at the end of 2023.

Similar inflation reductions in the US and other countries led bond markets everywhere to hope for a reversal of the rapid rate rises that had been used to battle inflation. However, early in 2024, the pace of inflation deceleration slowed and markets wound back rate cut expectations.

At the time of writing (mid June), fewer than three rate cuts from the Bank of England are now anticipated by UK bond markets into 2025. This big change in expectations, from six to three cuts, is a big reason for poor bond market performance throughout this year. 

Has the fight against inflation been won?

Inflation has fallen a long way, but central banks need to see move evidence before they can act. Chart 1 shows what is known as the 'three round effects' of UK inflation.

First round effects are the most volatile price changes, such as for example a spike in energy prices after a supply shock. Second round effects refer to the gradual increase in prices of semi-durable products that need to be bought frequently, such as toothbrushes. Services, such as a gym membership, make up the third round effects. 

Chart 1 shows the three categories of inflation over time. It shows rapid deceleration in the first round inflation effects - and a less pronounced, but still downward trend in second round effects - that has excited the bond market since 2021. However, equally, it also shows that inflation in respect of services still remains above 5% in 2024. 

Chart 1: Three rounds of UK inflation since 2010 (%)

Source: Macrobond, Nutmeg, data points compared to one year previous

In addition to semi-durables, Chart 2 shows the goods basket according to durable goods (products that do not need to be purchased often, such as home appliances and cars) and non-durable goods (those that need to be bought frequently, such as cleaning products and cosmetics). This data is on a three month basis so shows a slightly different picture from Chart 1, and excludes those first round goods mentioned above.

Chart 2: Non-durables vs semi-durables vs durables since 2021 (%)

Source: Macrobond, Nutmeg

The data for core goods shown in Chart 2 are three month percentage changes. Price rises are clearly no longer slowing, which will be the cause of headaches at the Bank of England as it seeks to find a clear passage towards a rate-cutting cycle. Even the recent rate cut announcement by the European Central Bank was coloured in cautious language in how far it can cut. 

The importance of a negative correlation between equities and bonds

One independent measure of how the battle against inflation is progressing is to look for the re-emergence of a strong negative correlation between bond and equity returns. As my colleague, Pacome Breton, discussed last year, historically, the mix between equites and bonds has worked well due to diverging cycles of performance of those two asset classes. At any particular time, as one might be performing poorly, the other would be doing well - a negative correlation. 

Typically, the economic cycle leads the inflation cycle by up to 18 months, which is why economists call inflation a 'lagging indicator'. The 'dog wagging its tail' is a good analogy here. Normally, the economic cycle ('the dog') tells us what we need to know about future inflation ('the tail').

Also in a typical cycle, the correlation between bond and equity returns is negative as monetary policy reacts mainly to the growth cycle. Stronger growth leads to higher equity prices and interest rates, but these higher rates lower bond prices.

Negative correlation is the normal case, but not the current case, as shown in Chart 3.

Chart 3: Three-month correlation between daily US equity and bond returns since 1990

Source: Macrobond, Nutmeg

Since the Covid pandemic, we've seen instances of supply disruptions, employees demanding wage growth to match inflation, and some business raising prices in excess of inflation. This behaviour has heightened inflation anxiety in us all. 

For financial markets, this anxiety especially relates to how long official monetary policy will be fixated on the fight against inflation rather than supporting growth. This is a case of 'the tail wagging the dog' and results in positive correlation in bond and equity returns. This is shown in Chart 3, as when the line is above the zero mark, it's a positive correlation, and a negative correlation when below zero. We can clearly see more evidence of positive correlation since 2021. 

Raising interest rates to fight inflation usually hurts both bonds and equities (the latter because prospects for demand and profits worsen); a positive correlation.

A return to negative correlation would signal to us that financial markets understand central bank policy responses, and that the focus of attention is shifting away from inflation towards the growth cycle.

Do Nutmeg investment portfolios protect me from inflation?

All Nutmeg portfolios have some element of equity exposure, which in most 'normal' market environments can offer a partial buffer against inflation. As headline inflation rises, listed companies also have the power to raise their prices in response. In theory, their revenues too will rise, and so boost share prices. However, in times of positive correlation when both equities and bonds go down together, then the portfolios will suffer. 

Nutmeg customers with the lowest appetite for risk have 10% equity exposure. Global equities returned 10.5% in the first five months of this year, offsetting the 0.85% fall in global bonds (hedged to sterling). So year-to-date returns are positive in the portfolio despite weaker bonds. This is true for Nutmeg's whole risk-range of portfolios.

What's the outlook for bonds? 

Despite changed expectations around interest rates, Nutmeg is optimistic about bond markets for long-term investors, a view shared by our colleagues in the Market Insights team at J.P Morgan Asset Management.

The higher-for-longer interest rate environment has meant that the main source of investor returns from fixed income has changed, from capital growth to yields. When interest rates are eventually cut, falling yields (and accompanying increases in outstanding bond prices) should mean we see a re-emergence of attractive capital returns.

While inflation remains a little “sticky”, the J.P. Morgan Asset Management Market Insights team does not expect to see a major re-acceleration in inflation over the second half of 2024. The team thinks that, even with inflation still above central banks’ targets of 2%, the next move on interest rates is likely to be lower.

After the ECB cut in June, it seems the Bank of England may well be next, with the Federal Reserve also likely to follow suit by cutting rates before the end of the year.

What is the Nutmeg Investment team doing with bond exposure? 

The Nutmeg investment team believes that the current late stage of the monetary policy tightening cycle should  be a positive for government bonds. The team stands ready to increase portfolios' exposure to bonds above the current neutral stance (against the portfolios' long-term average) when the environment permits. 

However, the team also adds a note of caution for not yet celebrating victory over inflation. Nutmeg is watching announcements by monetary policy makers, as well as bond market reaction, closely. The team is also keeping a close eye on important indices for wage and services inflation. 

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. These figures refer to past performance, which is not a reliable indicator of future performance. Forecasts are also not a reliable indicator of future performance.