Bonds are still not cheap, but they will have to do.

The English-speaking world loves how the Germans create word mash-ups to express phrases. "Zeitgeist" and "Schadenfreude" are ever-popular. Over the past week,"Zeitenwende," turning point, has been applied to express the West's interest in supplying arms to Ukraine. It also applies to financial markets this week. A few months ago I highlighted how we were in a regime where "bad news is good news." Signs of a slowing economy boosted equity markets on the notion that the Fed would need to tighten less. Irrespective of how much weight you give to this week's retail sales report, stocks didn't like it. We now are back to "bad news is bad news." This simply means the markets have become comfortable with the terminal point of Fed hikes. 

This is not new news, though I have disagreed with this view until now. I have come around to the idea that the accumulation of data showing the economy is slowing is enough to put inflation on a durable downward trend. As a result I am begrudgingly adding duration to my portfolio. I do this with no enthusiasm because I remain a fixed-income value investor and the values are not compelling. They will have to do, though.

My framework for thinking about value relies on requiring a decent positive real yield for long-term bonds. Yields in the 3.5%-ish range are not quite decent if we accept that long-run inflation will be at 2%, but real yields will become positive, at least. I remain skeptical that we reach the 2% target range over the next year. There are a few structural issues that are likely to keep inflation higher than it would otherwise be. To name one, consider the general contraction of global trade. Sanctions against Russia will continue for years. Reshoring manufacturing and wariness about trade with China will continue for years. This unwinds some of the disinflationary effects we've enjoyed from globalization over the last few decades.

A repeat of the great recession, or worse, would drive policy rates back to zero, but I don't think that should be the central case for investors. Remember, also, the Fed is determined to create a "positive real rate" environment and that it believes the "correct" long run inflation rate is 2%. Whatever your belief about the Fed's ability to pull the strings, a 3.5% yield at the longer part of the curve is the low end of what I believe the Fed will continue to guide to. We'll earn a miserly 1.5% after inflation.

In past cycles I was fond of pointing out that inverted yield curves pushed investors to the wrong part of the curve. Higher yields at the short end encouraged positions there when the big money was going to be made at the long end as yields fell. I so wanted that to be true again this time but apparently not. As noted above, there is no juice at the long end. What little price gains are to be made are at the shorter end of the yield curve.

While adding high quality, short-maturity bonds makes sense now, what you should absolutely not do is go down in quality to pick up yield. The credit cycle is still playing out according to form. If we are almost done with rate rises the recession is still to come and the spreads on lower-rated bonds are going to widen out. These same forces will weigh on stocks. The time to buy stocks is when the Fed has begun its easing phase and we are not there yet, obviously.

The chart above shows the no good, bad, terrible year both bonds and stocks had in 2022. If I am right we will see the divergence between these two lines grow in favor of fixed income. Good luck, folks.