Advocates of formulaic investing along the lines of 60 percent stocks, 40 percent bonds are not doing so well these days. Year to date, bond indexes are down about 13 percent. This is the second consecutive year of negative returns from fixed income. While this may be better than the twenty percent decline in stock indexes, it is still shocking to those who advocate asset allocation as the be and end all of investment management.
Over extended periods of time bonds have lower variability of returns. This has been translated by some as being less risky. Yet buying almost any debt of medium to long term in the face of rising interest rates seems a curious way to diversify. Higher interest rates mean loss of value for an instrument that pays periodically and returns principle at maturity. The longer the time to maturity, the greater the potential loss of value. While such losses in principle can be recouped if the bond is held to maturity, the purchasing power of the funds returned can be less than when they were invested. If one is invested in a bond, ETF or mutual fund, the participant has no control of a decision to sell the bonds in the portfolio, locking in the loss in the process. Should there be material redemptions from the bond fund, liquidating losses cannot be avoided.
Ah, but you say that stocks, while posting higher returns over time, have higher variability of returns and thus must be riskier than bonds, correct? Not really. Stocks can raise dividends, which acts as an inflation hedge. They can buy back stock, which can improve the value of the remaining shares. The company they represent often can raise prices, which funds the rising dividends. Bonds, which are contractual obligations to repay money, typically have none of the features of stocks.
Bonds have had a very well forty-year run since the days of Paul Volcker (1979). Then interest rates soared to over thirteen percent, to the post-2008 period, when interest rates came close to zero. Since companies benefitted from falling interest expenses favorably influencing corporate profits, stocks did well in tandem with bonds during this time frame. Bond investors also did well, as falling interest rates made older bonds worth more because they paid more than subsequent issues.
The future will not look like the past. With soaring inflation world-wide, interest rates will rise until there is again a real (after inflation) cost to borrowing. While this may cause economic dislocation in the short run, the expectation of interest rates returning to their lows is wishful thinking. As other countries are swept along in the increasing cost of money, look for lower economic growth world- wide going forward. Add to this the loss of trust between countries caused in part by the pandemic, and a lot of the benefits of free trade become history.
More recent investors see this as the end of an era. Those of more advanced age see a return to an earlier time. Six percent mortgages were common as recently as the 1990s. Even in the Great Depression of the 1930s, government bonds seldom went below four percent at issuance. As for international trade: the economic philosophy of comparative advantage, where each country would make what they were best at depended on a rational world. The image of such a world was destroyed by Russia’s invasion of Ukraine and China’s willingness to end relationships over Taiwan. Russia’s willingness to disrupt its principal exports of oil, gas and gold for territory shows how countries can subsume economic attainment for political influence. Both countries also found the creation of external threats a convenient distraction from the shortcomings of those in power. Neither of these events are economically rational, yet they do exist
The next shoe to drop will probably be currency. As of now, the value of the US dollar relative to the currency of most other countries is strong, fueled by foreign investors buying dollars to acquire US dollar bonds with their high risk-adjusted interest rates. As other countries raise interest rates the US dollar should decline in value. A decline in the dollar would cheer on other nations who feel that it is US interest rates that are disrupting their own economies. If the US dollar does fall, it would have an immediate domestic inflationary impact which could prolong the elevated interest rates currently witnessed. Imports would cost more as they would require more US dollars to buy.
Economic activity is slowing but not yet negative. Ironically, most of the layoffs in the economy to date are in the technology and management ranks. Economists are wondering if this will be the first white-collar recession. Blue collar jobs still have two openings for each applicant.
Many companies are coping with sharply higher inventories as sales stalled out in May and June and have not resumed. Clothing vendors seem to be especially hard hit, as deep discounts are being required to move merchandise before it goes out of fashion. Supply chain issues seem to be getting a bit better. Ports are being streamlined to operate more productively.
Inflation is slowly coming down. We are close to lapping the upsurge in prices of a year ago. Housing is a continued hot spot, as is transportation.
The Federal Reserve has stated that they will keep raising interest rates until the cost of borrowing exceeds the inflation rate. Their goal is to reduce inflation to two percent per year. The consensus currently is for the Fed to raise interest rates to 4.4 percent and keep them there until sometime between late 2023 to 2025.
To acknowledge that interest rates are going up is to state the obvious. The key issue is how high they will go and for how long.
Assuming the goal is 4.4 percent, this could be attained by year end. How long it will be required to stay at this level is anyone’s guess. There is some speculation that a major event like a large bank failure or a currency crash would compel the Fed to relax interest rates earlier. It does not appear that many are banking on such a scenario.
The Stock Market
Stocks are undergoing a rotation. Shares of companies that have good prospects of raising dividends seem to be the best positioned. Companies in industries where competition is rising may have sub-par returns. This would seem to include most of technology.
Going forward, the cash return component in the form of dividends will be critical to returns on stock investments. Stocks that do not pay a dividend will have a high bar to clear compared to the recent past. This also includes stocks that do not earn their dividend as it will be assumed that such dividends will be reduced or eliminated at some point.
Warren M. Barnett, CFA
September 27, 2022
Statements made within the Perspective are those of the author and should not be considered as individual investment advice. For personal investment advice, please contact the firm at 423-756-0125 or