During periods of acute volatility, it’s helpful to take a long-term view of financial markets, not only to put recent swings in context but to prepare for what may lie ahead.

Recent moves in economic data, monetary policy, and financial markets have involved magnitudes not seen in decades. Inflation, as gauged by the Consumer Price Index (CPI), this month hit a 40-year high of 8.6%. The Federal Reserve responded with its biggest interest-rate hike since 1994. The average 30-year mortgage rate rose to the highest level since 2008, according to Freddie Mac, on the biggest weekly climb since 1987. Major equity indexes have fallen into bear markets, down more than 20% from recent peaks, while bonds have suffered by far the worst start to any year on record.

Investors are keenly aware of the losses that have been inflicted on even the most diversified portfolios. And there’s no guarantee that an end is in sight. But there are signs that, as in past steep market declines, the current losses are resetting valuations to levels that can prove attractive to investors who stay focused on the long term, with potential diversification benefits also improving. Based on recent indications of where the economy may be heading, we believe the investment outlook has become more constructive, particularly for bonds.

The Fed attacks inflation, at a cost

Financial assets and the economy are getting squeezed as the Fed tightens financial conditions in its intensifying quest to quell inflation. Consumers are feeling the effects of higher inflation, too. Retail sales fell 0.3% in May, according to Commerce Department data. A University of Michigan gauge showed consumer confidence fell in May to the lowest level on record. The spike in mortgage rates has caused existing home sales and housing starts to slow.

As a result, the likelihood of a recession appears to be rising. As of 16 June, the Federal Reserve Bank of Atlanta’s GDPNow tool estimates that the U.S. economy will show no growth in the second quarter of 2022. And the recent slowing in growth likely doesn’t yet reflect the full extent of tightening so far, given the usual lags between tighter financial conditions and slower growth.

Bonds tend to perform well during recessionary periods, and if the Fed succeeds in bringing inflation lower, it could create an even stronger backdrop for fixed-income investments.

One of the best gauges of forward returns for bonds is the starting yield. The surge in yields since the start of 2022 – the 10-year U.S. Treasury yield has risen to about 3.25% from about 1.63% – has inflicted unprecedented price losses on existing bonds (see Figure 1). But it has also created a better starting point for new investments in terms of both potential income and diversification attributes – two of the bedrock reasons for owning bonds.

Treasury yields have risen partially in response to expectations for Fed policy-rate hikes. When the Fed on 15 June raised its policy rate by 75 basis points (bps), officials also revised higher their median projections for that rate to about 3.8% next year.

At the same time, Fed Chairman Jerome Powell noted that the long-run neutral interest rate – also known as R-star, where monetary policy keeps the economy at an equilibrium – is still relatively low, in the mid-2% range by the Fed’s estimate, which is consistent with PIMCO’s views. That points to the Fed pursuing a restrictive policy-tightening cycle, and the projections suggest officials are unanimous in their belief that the policy rate needs to rise above neutral, despite the cost of slower growth.

In 1994, the last time the Fed raised rates by 75 bps at once, it was fighting concerns about inflation that never fully materialized. Then, the Fed began its hiking cycle slowly and accelerated, with bond yields peaking before the final hike. This time, the Fed is hiking more aggressively early on, raising the possibility that yields may peak well before the Fed reaches its ultimate policy-rate target.

With the U.S. 10-year yield at about 3.25%, Treasuries could provide positive real yields – in a comparably safe and liquid asset – if you believe the Fed can get inflation back down even close to its target level. There are relatively defensive areas of fixed income markets that are now offering more attractive yields than we have seen in some time. That has helped increase both potential income and the margin for error for investors.

Recent months have been cause for anxiety in all corners of financial markets, with many cross-currents for investors to figure out, including persistent inflation and geopolitical tensions. Uncertainties linger over when market momentum might eventually turn.

Over the long history of financial markets, there have been routs that have been similarly painful to the one investors are experiencing this year. As has happened in the past, these declines can help reset asset valuations and set the stage for better days ahead.

Learn more about PIMCO’s approach to active fixed income management.

Marc P. Seidner is CIO Non-traditional Strategies.