Nowhere to Hide
By Paul Morrone, CFP®, CPA/PFS
Let’s get the bad news out of the way. Broad indices for both stocks (S&P 500) and bonds (Barclay’s Aggregate Bond Index) are down roughly 10% YTD through the end of last week. While negative short-term performance, alone, is not really a headline, the fact that stocks and bonds have been moving in lockstep has made the drawdowns feel more painful than they appear on the surface. This means investors have not felt the benefits of diversification that typically become clear during periods of stock market volatility, when bonds are expected to have more price stability than stocks and lessen the blow of a pullback.
But volatility is expected in equity markets given their sensitivity to the news cycle and people’s emotions. Over the last few months, alone, we could point to a dozen headline news stories powerful enough to send investors home with their tail between their legs: Omicron 1.0 & 2.0, Inflation, Russia’s invasion of Ukraine, the Fed, and supply chain shortages, to name a few. If you were looking for a reason to hide, the world gave us no shortage of them. Equity investors tolerate (… we didn’t say enjoy) dramatic short-term price swings with the hope that their patience and discipline will be rewarded with higher long-term rates of return when compared to less volatile investments, such as core fixed income. That makes the past few months even more of an anomaly as the Barclay’s Aggregate Bond Index (the industry benchmark index for investment grade bonds) is off to one of the worst starts to a year ever, with losses surpassing even equity markets through the end of the first quarter.
It’s rare that we see interest rates make headlines in mainstream media they way they have recently, but there are exceptions, and this is one of them. From the yield curve inversion to Fed interest rate policy to the unwinding of the Fed’s balance sheet, not to mention inflation, there has been no shortage of public commentary related to the fixed income markets. To most, this may sound like industry jargon, and few without a robust background in capital finance can accurately articulate what much of this even means, never mind interpret the implications to the average investor. Nor should they.
Speaking of the Fed, Chairman Powell said last month that the economy was on firm footing and would be able to withstand rate hikes, reinforced by his April comments where he noted that larger hikes were “on the table.” In other words, the Fed isn’t worried about a recession quite yet. Supporting that theory is the fact that parts of the yield curve are at their steepest level in recent past, an indication of healthy markets. Credit markets seem to agree with Powell’s assessment as evidenced by the fact that high-yield bonds (which carry more risk) have outperformed long-term Treasuries notes (typically deemed to be the ‘safest’ type of fixed income), which leads us to believe credit markets are less worried about future economic growth than it may first appear. It would be a far more troubling sign if the opposite was true. “To see credit markets showing major signs of improvement the past few weeks is a great sign that financial conditions are probably better than most think,” explained LPL research Chief Market Strategist Ryan Detrick. “Yes, the yield curve is flashing some warnings, but overall, the credit markets are saying don’t get overly worried just yet.”
Seen as the smarter, patient and wiser counterpart to equity markets, market researchers often relay on trends in fixed income trading as a basis for the future of equity markets as well. As markets and investors continue to digest the implications of higher interest rates and what that means to future expected returns across all asset classes, we want to highlight that the news isn’t all bad. There may even be a silver lining. “It has certainly been a rough start to the year for core fixed income investors,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “But higher yields mean there is now an opportunity to invest at better valuations, which may mean future returns for bonds have improved.”
This is by no means meant to imply that we’ve reached the bottom or that volatility won’t persist in the future. Remember, financial markets are impacted by a myriad of different data points, and new information constantly being introduced into an infinitely complex ecosystem. Fortunately, the US Consumer, the lifeblood of our economy, is well positioned to weather a storm that is seemingly being triggered by inflation and the prospect of higher interest rates. We’d be remiss not to mention a few key points that illustrate how far we have come since 2008.
- Household debt relative to household net worth is at historically low levels. This means that people dedicate less of their income and net worth to debt service costs, giving them more discretionary spending power.
- Consumers have more cash on hand than at any other time in history. Nearly $4.0 trillion is sitting in bank deposits. For reference, this is nearly 10x greater than the amount of cash consumers had immediately preceding the ’08 financial crisis. More cash available means we may be able to withstand the adverse effects of inflation over a longer period of time.
- Still reeling from the after-effects of COVID lockdowns, there remains pent up demand for travel, services and discretionary spending.
As you are reviewing your first quarterly statement this year, remember how far we have come in such a short time. We’re (barely) two years from the market bottom in 2020 when the S&P hit a low of 2,237. Today it is nearly double that value, at one point eclipsing a 100% increase from those dark days prior to this quarter’s pullback. While fixed income investors have had a rougher ride, we want to remind you that a well-balanced and diversified approach never goes out of style. We also know that diversified strategies, by design, do not work every day (as that would imply the ability to make perfectly timed decisions – an impossibility to say the least), but should work more days than they do not – which is the key to long-term success. Borrowing some wisdom from the famous Oakland A’s manager, Billy Bean, diversified portfolios are designed to achieve the highest on base percentage – not chase home runs and grand slams. And if you haven’t taken the time to watch the movie, Moneyball (based on Billy Bean’s story as manager of the A’s), do yourself a favor and make it priority!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All investing involves risk including the possible loss of principal. No strategy assures success or protects against loss.
The content is developed from sources believed to be providing accurate information.