War-torn bonds may rally if recession hits

INVESTORS seeking safety from the Iran war just ran into harm’s way. Government bonds and gold have both failed to protect portfolios.

Gold at least has an excuse – it had already doubled last year – but bonds have never really recovered from the Ukraine invasion and may well need an outright recession to perform again.

It’s not easy to keep tabs on the Iran conflict day to day or the financial fallout. But since the first attacks on Feb 28, two things have been clear: energy prices are significantly higher, and neither bonds nor gold has offered any haven.

Gold’s worst month in 43 years is a bit of a puzzle. Supposedly a safe harbour in times of global stress and a hedge against inflation, gold’s proven to be neither.

The simplest explanation: gold’s parabolic surge last year was already pricing in these risks, before getting whipped into a speculative frenzy of its own. Now it is being sold to meet liquidity needs.

Government bonds are a different matter. They sit squarely at the heart of conservative fixed-income funds and act as ballast in mixed-asset portfolios, helping soften the blow from big stock market drawdowns.

A flight from stocks and relatively risky assets would typically see money cling to “safe” government bonds. But not this time.

The prospect of both an oil-fuelled inflation surge and hawkish central bank tightening to counteract it have overwhelmed bonds again, pushing yields higher to compensate for both rising base rates and inflation expectations.

“The Middle East conflict is a reminder that the Achilles’ heel of a 60-40 equity-bond portfolio is an inflation shock,” writes Ulrike Hoffmann-Burchardi, UBS Global Wealth Management’s Americas chief investment officer and global head of equities. “In this scenario, both sides of the portfolio lose money.”

She estimates a typical 60-40 mix is down 3.5% this year and argues that diversifying further into commodities with scarcity premia may now be warranted.

War bonds

Perhaps the most striking question is why government bonds are ever considered a safe buffer during wars at all.

A paper published last week on the Centre for Economic Policy Research’s VoxEU site analyses 300 years of government spending shocks – from major wars to the Covid-19 pandemic – and finds that government bonds repeatedly generated substantial real losses during these episodes, even underperforming equities and real estate.

Over three centuries, wars have typically triggered large, sudden increases in US and British government spending averaging about 7% of gross domestic product (GDP) annually in their first four years.

And that spending is rarely met by higher taxation alone.

“Wars are always disaster times for bondholders,” the paper concludes.

Bondholders suffer average real losses of 14% during the first four years of crises, with cumulative returns running some 20% below stocks or real estate.

By contrast, bonds outperform during recessions and financial crises.

Nominal returns during war periods were positive, but inflation destroys the real calculation – often deliberately, as governments have historically sought to inflate their way out of mounting war debt.

Both America and Britain suspended various iterations of the gold standard during wartime for exactly this reason.

“Financial repression” – such as US Treasury yield capping during World War Two or British moves to lock in creditors – compounded bondholder pain and helped cut debt-to-GDP ratios after conflicts ended.

“Government bonds provide insurance against many types of economic downturns, including financial crises and recessions,” the paper notes, adding that governments had to decide between big hits to taxpayers and lingering risk. “But they perform poorly precisely in states of the world associated with large fiscal shocks.”

Four years of pain

Many investors are hoping this conflict is measured in weeks, not months. The nature of modern wars might support that hope – though the Ukraine war is now entering its fifth year, with no clear end in sight.

Already, government bonds are clocking losses. Exchange-traded funds tracking Treasuries and the Bloomberg Multiverse global government bond index are both down 2% in March.

Neither index has recovered from the inflation and interest rate shock that followed Russia’s invasion of Ukraine in 2022. Both remain down 14% over five years.

Central bank rates have settled higher than pre-pandemic levels – and despite coming off recent highs, another sustained inflation burst could push them back up.

In America at least, the fact the inflation and rate shock four years ago did not trigger a recession is telling – as inflation and Federal Reserve rates are settling at higher levels than before the pandemic and prolonging the pain for bondholders.

Whether bonds need recession to truly outperform again is now the big question. Only then would central banks likely floor rates again as any price pressures would be drowned by collapsing demand.

An energy squeeze and cost-of-living shock may well do that eventually. But war alone won’t boost bonds. Quite the opposite. — Reuters