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Bond portfolios have fallen deeply in the red this year as the Federal Reserve has jacked up rates to fight stubbornly high inflation, spurring an epic repricing in swaths of the $53 trillion U.S. bond market.

Debt no longer is cheap for U.S. households, businesses or the government to borrow. And without the jet fuel of easy credit, many economists and chief executives also think a recession could lurk around the corner.

The pain to portfolios has been a bitter pill for investors to swallow in 2022, particularly with Goldman Sachs equity analysts forecasting this week that the S&P 500
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+1.36%

will end next year at 4,000, or roughly flat from current levels since “the cost of money is no longer next to nothing.”

On the flip side, however, higher Fed rates also mean investors finally can earn a return by serving as creditors again, with bonds now kicking off some of the highest yields since the wake of the 2007-2008 global financial crisis.

A big question heading into next year is whether higher yields should be viewed as red flag, a sign of more carnage to come as borrowers and businesses struggle to avoid default, or a green light to invest?

“One way to think about it is that we’ve been in a pitch black, dark room for years, and now someone switched the light back on,” said Steve Foresti, chief investment officer of global asset allocation and research at Wilshire, about the move away from ultralow rates and negative bond yields.

“It’s disorientating, but the path forward does become clearer. Investors are right in the middle of that adjustment,” he said. “There also are some returns priced in now that fixed-income investors can work with.”

See: Where in 2023 to find some of the best returns on bonds in two decades, according to Goldman Sachs

An S&P 500 bottom? It depends on the Fed

Foresti said the Fed’s attempt to balance its inflation fight with a desire to avoid destroying the economy still could be playing out over several more quarters, which could keep markets volatile.

The Fed’s policy rate already has jumped to 3.75% to 4% from nearly zero a year ago, with another increase of at least 50 basis points widely expected at the central bank’s December meeting. The pitched inflation battle has led to forecasts for a “terminal,” or peak, Fed rate of 5% or higher next year.

But as Chris Haverland, global equity strategist at the Wells Fargo Investment Institute, pointed out in a Tuesday client note, no S&P 500 bear market (see chart) since the 1970s has found a bottom before the last rate increase in a Fed tightening cycle.

No S&P 500 bear market since the ’70s has bottomed until the last Fed hike in a tightening cycle


Bloomberg, Wells Fargo Institute

With that top of mind, Haverland’s team recommends investors keep a defensive stance in 2023 “until the Fed signals a change of course, and interest rates stabilize or peak,” as they expect to happen next year, but also potentially coincide with the U.S. economy potentially being in a recession.

The Dow Jones Industrial Average was up nearly 400 points Tuesday
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+1.18%
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looking to rally after back-to-back losses, while the S&P 500 was up 1.2% and the Nasdaq Composite Index was 1% higher.

The risk-free 2-year Treasury rate
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4.529%

was near 4.5% on Tuesday, or above its 10-year
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3.768%

counterpart at almost 3.8%, providing meatier yields for investors but also signaling jitters about the short-term outlook for the economy.

Read: Bond-market recession gauge flirts with milestone as global growth fears mount

No Fed ‘rescue’ baked in

Unlike earlier this year, few investors now appear to be counting on the Fed to ride to the rescue of financial markets, as the central bank had done twice since 2000 by slashing rates and starting emergency bond purchases to keep liquidity flowing.

Only four months ago, the expectation was for the Fed’s policy rate to peak in the 3.5% to 3.75% range, or below the current level. BofA economists also were forecasting a Fed rate cut in September 2023.

But as of Tuesday, the odds of the Fed’s rate falling back to a 3.5% to 3.75% range for the December 2023 were only 0.1%, according to the CME FedWatch tool.

“Certainly, we all know the journey that got us to this point,” said Lindsay Rosner, a multisector portfolio manager at PGIM Fixed Income, in a phone interview, about the rout in financial markets tied to aggressive tightening this year by the Fed.

“Where we sit now is one with really exciting yields and really good spread. But it is not without risks,” Rosner said. “This isn’t a market where you close your eyes and buy anything.”

Rather than chase riskier parts of the bond market, Rosner’s team likes U.S. investment-grade corporate bonds, where yields have climbed to about 5.6%, or near levels last seen in 2009, and high-quality parts of the securitization market where investors can gain exposure to U.S. consumers.

Foresti at Wilshire said stocks, bonds, inflation-protected securities and alternatives, like oil
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+1.36%

and other commodities, still have a place in portfolios in the year ahead, even if the path to lower inflation looks cloudy and investors worry about having missed a peak entry point.

PGIM Fixed Income also continues to expect that the central bank won’t go overboard with its inflation fight.

“Our house view was never that the Fed would overtighten,” Rosner said. “Hiking to cut means you did something you didn’t mean to do.”


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