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How a return to a ‘5% world’ could break the market, Bank of America says

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The convergence of a slew of inflation-related metrics around the 5% level could spell big trouble for investors ahead, according to Bank of America. After living for two decades in what essentially was a 2% world, the elevation of inflation rates , wages, bond yields, and benchmark interest rates are surging and could stay there for a while. That’s a new climate for financial markets that had been feasting on moderation and stimulus from the Federal Reserve that has gone away. “Reversion to ‘5%’ could break the market,” Bank of America analysts said in a note analyzing the new environment. “Historically, it takes an average of 10 years for a developed economy to return to 2% inflation [after] the 5% threshold is breached,” they added. The move from an environment where inflation, wage growth and longer-term bond yields in particular hung around the 2% level has come to an end as multiple factors have pushed those metrics to points they haven’t seen in decades. BofA thinks unemployment also will begin drifting up to that 5% level. In response to rising prices, the Fed has pushed up benchmark rates to a 3%-3.25% range that in turn has sent Treasury yields soaring. Along with the rate hikes, the Fed is shrinking the size of the asset holdings on its balance sheet — $156 billion since early June, and more when factoring in the $120 billion a month bond-buying pace that held until earlier this year. Reversing those changes won’t happen overnight, the bank said in the report. For investors, that means a paradigm shift from the time-honored 60/40 portfolio split between stocks and bonds. That particularly combination lost more than 27% in the first three quarters of 2022, the worst performance ever, according to Bank of America calculations. A better combination for the future is one that is not correlated to the traditional mix as tighter financial conditions put pressure on cyclical stocks have benefited during the era of low inflation and bond yields. Bank of America favors energy, staples and utilities in this environment. “We expect 60/40 to underperform long term as de-globalization, energy transformation, and aging demographics push yields and inflation higher,” the note said. “Investors should consider rotating out of exposures that move with 60/40 and into exposures that offer more of a hedge.” The firm noted that two decades of low growth, inflation, interest rates and yields “yields created $70 trillion of growth stocks and government bonds priced for a minimal growth regime.” The analysts cautioned that there could be short-term rallies in things such as tech stocks and government bonds, but that investors should use those occasions to move into “value, energy and other less correlated assets.”

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