What We’re Thinking

We’ve discussed the August stock market update, but what about the bond market, or “fixed income,” as it’s also known in financial industry jargon?

Interest rates have risen significantly over the past year and a half, as the US Federal Reserve and central banks around the world have worked to contain inflation. When interest rates rise, bond prices decline, and when rates fall, prices increase (we’re happy to explain this relationship in more detail to anyone who’s interested). This is why bond prices declined so much in 2022 (down 11% for Vanguard’s intermediate-term bond fund), when the benchmark 10-year Treasury rate increased from 1.5% to 3.88%.

This year has been a somewhat different story. Rates have risen further, to 4.09% as of the end of August. So prices have declined, but the offset is that investors are now earning interest at the higher rates. The combination of more interest and slightly lower prices has resulted in gains of about 2% for Vanguard’s short-term and intermediate-term bond funds, and more than 5.5% for the high-yield bond fund.

There are, however, fixed income alternatives that are not subject to price declines as rates rise. These include “purchased” money market funds (PMMFs), which maintain a steady $1 per share price and currently yield in the 5.25% range. You can also buy short-term Treasury bills, which are yielding about 5.45% (for three-month terms) and 5.5% (for six-month terms). As long as you hold these Treasuries to their short “maturity” dates, there are no price declines. By contrast, the yield on the Vanguard bond funds are currently in the 5% range.

At the beginning of 2022, when PMMFs and short-term Treasuries had rates close to zero, there was no question for PPA that the fixed income portion of a diversified portfolio should be invested in bond funds, which were yielding 2-3%. Now, with short-term rates higher than longer-term ones (a situation known as an “inverted yield curve,” which we’re also happy to discuss further if you’re interested), it’s a tougher call. As you know, we never recommend trying to time the markets (in this case, selling all your bond funds to buy PMMFs). But if you have cash available for investment in fixed income, it’s likely to make sense to consider, in consultation with your advisor, a mix of PMMFs, Treasuries, and bond funds.

We will continue to monitor these changes in the markets and are always happy to discuss how they relate to your specific situation.

Maybe you thought the August stock market update would be dismal. To be fair, there’s some truth to that.

US stocks, developed international stocks (from countries in Europe and Japan), emerging international stocks (from countries including China, India, and Brazil) … markets from literally all over the world were down during the month of August.

And yet if we widen the time frame a bit, we discover that this year has been quite favorable so far.

Rather than zeroing in on a single month, let’s take a look at 2023’s returns through the end of August. Furthermore, let’s compare them to 2022’s returns through the same point last year.

Even with August’s declines, compared to last year’s returns during the same time frame, stocks were up by the end of August – and in some cases, significantly.

It’s important to note that this year’s gains began at the end of last year’s losses – in other words, there was lost ground to make up for.

Yet it’s also worth pointing out that anyone who decided to exit the market during last year’s downturn would have missed out on the gains we’ve seen in 2023.

The danger of selling while the market is low is that nobody knows when stock prices will increase again. So, in addition to losing out by selling low after buying higher, you also run the risk of later missing out on any recovery.

So, how do we help our clients avoid the risk of over-inflating the impact of a downturn – or worse yet, making decisions you’ll regret?

For one, perspective.

We can help you maintain focus on the big picture and your longer-term goals. Markets will fluctuate, and there will be down days and months – even years. But by taking a step back and focusing on the long term, however you define that term, we can maintain greater perspective.

More tangibly, we help our clients cushion volatility through a customized asset allocation. As you know by now, it’s your specific goals, timeline, and risk tolerance that informs the combination of assets (stocks, bonds, high yield bonds, and cash) selected for your portfolio.

If you’re risk-averse or working with a shorter time frame, one’s asset allocation will typically include fewer stocks – which generally mitigates the impact of downturns on an overall portfolio.

If you’re more comfortable with risk, or your timeline is longer, one’s asset allocation will typically include more stocks. Increased risk tolerance and/or a longer time frame can help prevent you from making emotional decisions that might trigger regret later.

It’s our job to get to know you, listen carefully, and design an asset allocation that suits your particular needs.

So as long as your time frame remains the same, and there haven’t been any major life changes that would require a change in asset allocation, there’s likely no need to make major changes to your portfolio.

You can move forward with August’s declines in your rearview mirror – and take time to appreciate (at least momentarily) this year’s stock market gains.

As you know, we avoid making predictions about where the stock and bond markets are headed. There are simply too many factors that impact the markets – economic, political, atmospheric too – over the short and long terms.

On the other end of the prediction spectrum, a Morgan Stanley analyst recently made the sheepish admission that “we were wrong. 2023 has been a story of higher valuations than we expected amid falling inflation and cost cutting” (The Street, 7/24/23).

The article goes on to say that the “admission is somewhat surprising given he repeatedly warned this year that the stock market rally would reverse. For example, he told Bloomberg in May, ‘We would characterize this as the bear market is continuing … The fundamental case does not support where stocks are trading today.’

“Those comments were made days before the S&P 500 broke out to a new year-to-date high, rallying by over 8%. The mea culpa hasn’t changed [Morgan Stanley’s] view, though. He remains ‘pessimistic on 2023 earnings.’”

He might be right about earnings, and that stock prices will decline as a result. But he also might be wrong again, multiple times. Why bother?

It’s not just inherently unpredictable factors – like wars, political coups, fires, and earthquakes – that make prediction so difficult, if not impossible. Even when we know something has happened, the markets can react in unexpected ways.

A recent example involves the question of when good economic news translates into good or bad news for the markets.

Jenna Smialek and Ben Casselman wrote about this in The New York Times in an article entitled “Maybe, Just Maybe, Good News Is Good”:

“It had been the mantra in economic circles ever since inflation took off in early 2021. A strong job market and rapid consumer spending risked fueling further price increases and evoking a more aggressive response from the Federal Reserve. So every positive report was widely interpreted as a negative development.

“But suddenly, good news is starting to feel good again … Recent data have been encouraging, suggesting that consumers remain ready to spend and employers ready to hire at the same time as price increases for used cars, gas, groceries, and a range of other products and services slow or stop altogether – a recipe for a gentle cool down.

“Economists and investors are no longer rooting for bad news, but they aren’t precisely rooting for good news either. What they are really rooting for is normalization, for signs that the economy is moving past pandemic disruptions and returning to something that looks more like the pre-pandemic economy, when the labor market was strong and inflation was low …

“One reason economists have become more optimistic in recent months is that they see signs that the supply side of the supply-demand equation has improved. Supply chains have returned mostly to normal. Business investment, especially factory construction, has boomed. The labor force is growing thanks to both increased immigration and the return of workers who were sidelined during the pandemic.

“Increased supply – of workers and the goods and services they produce – is helpful because it means the economy can come back into balance without the Fed having to do as much to reduce demand. If there are more workers, companies can keep hiring without raising wages. If more cars are available, dealers can sell more without raising prices. The economy can grow faster without causing inflation.”

This story appeared just after the S&P 500 index hit 4,589 on July 31, the highest level since the all-time high of over 4,800 in December 2021. The index was up 19.5% for the year, recovering much of the more than 20% declines from 2022.

But since August 1, the stock market has declined significantly, down about 4.5% through August 16. What changed?

On the bad news side, “Fitch ratings lowered the credit rating of the United States one notch to AA+ from a pristine AAA. The firm, citing a ‘deterioration in governance,’ along with America’s mounting debt load, suggested that it could be a long time before that decision was reversed.

“The move – like the drop to AA+ in 2011 by S&P Global, which has kept its US rating there – followed partisan brinkmanship over America’s debt ceiling, which caps how much money the government can borrow” (The New York Times, 8/2/23).

But then came further good news about inflation: “Fresh inflation data offered the latest evidence that price increases were meaningfully cooling, good news for consumers and policymakers alike more than a year into the Federal Reserve’s campaign to slow the economy and wrestle cost increases back under control.

“The ‘core’ inflation index, which strips out volatile food and energy prices … picked up by 4.7% from last July, down from 4.8% in June.

“The upshot was that inflation continues to show signs of seriously receding after two years of rapid price increases that have bedeviled policymakers and burdened shoppers – and the details of the July report offered positive hints for the future. Rent prices have been moderating, a trend that is expected to persist in coming months and that should help to weigh down inflation overall. An index that tracks services prices outside of housing is picking up only slowly” (The New York Times, 8/11/23).

It’s also possible that many market participants simply thought that stocks had risen too far, too fast, and started taking some of the profits earned earlier in the year.

Whatever the reasons for the market rise through the first seven months of the year, and the decline over the past three weeks, the main point is that we don’t know what will happen at any time in the future. So the attempt to interpret events as good or bad seems futile.

Instead, as we have emphasized in the past, Park Piedmont continues to advocate for clients to develop an allocation between stocks and bonds that’s appropriate for their specific, long-term situation. We recommend making significant alterations to that allocation only based on major life changes, not short-term price changes or news reports, whether they appear good or bad.

Stocks and bonds continued their 2023 recovery in June from the dismal results of 2022. Broad-based US stocks rose 16% through the end of June, while developed country stocks increased 11% and emerging markets stocks were up 5%. The tech-heavy NASDAQ index climbed almost 32% through half of 2023.

Bonds also had positive returns through June 30. With the benchmark 10-year Treasury remaining relatively high at 3.81%, down slightly from 3.88% at the beginning of the year, income has increased while prices have remained stable. US bonds rose 2.6% in the first half of 2023, while high-yield bonds increased 4.4% and inflation-protected bonds were up 1.8%.

Interest rate increases by central banks around the world, attempting to contain inflation without causing recession, remain among the most closely watched economic indicators. The US Federal Reserve is focused on engineering a “soft landing” from the historic inflation in 2022, but opinions differ as to whether that will happen.

As Talmon Joseph Smith writes in The New York Times, “For a year or more, worries about an impending recession have dominated discussions about the economy. Most economists expected a recession to hit the US by now – in part because of the rapid escalation of interest rates. That increase in the cost of credit has caused shocks in the banking sector and, for a while, put a lid on the housing market.

“But the dampening effect of higher rates has confronted the robust income and spending of many households and the staying power of businesses – both buttressed by emergency pandemic support from Congress and the Fed. Though families, business managers and investors alike have had to contend with the frustrating realities of inflation and economic uncertainty, growth has continued, almost defiantly.”

“[But] a growing cohort of investors believes that sustained growth could plant the seeds of its own destruction, as the Fed reacts by keeping borrowing costs higher for much longer than businesses have anticipated. That could make some debt burdens unsustainable for businesses, especially those that rely on loans or lines of credit from banks or that may need to seek new funding from investors.”

Matt Grossman, writing in The Wall Street Journal, suggests the possibility that rates need to be even higher than they are now, possibly beyond the one or two additional rate increases expected from the Fed later this year:

“Investors generally expect higher interest rates to cool the economy, as part of the process known broadly on Wall Street as “tightening financial conditions”—a constellation of higher mortgage rates, rising bond yields and generally lower asset prices. Together, these factors tend to reduce the amount of money coursing through markets, for instance by making it harder for people and businesses to get loans.

“But one complication is that it is hard to know in real time whether conditions are actually tight or whether they just look that way, particularly when inflation… hit its highest level since the early 1980s.

“Understanding whether financial conditions are tight or loose is challenging because a key variable is hidden from view, economists say. What matters isn’t the absolute level of the Fed’s target rate, but rather whether it is higher or lower than a hypothetical “natural” rate that would neither slow nor stimulate the economy.

“Economists say that financial conditions only tighten when market interest rates rise firmly above the natural rate. The natural rate can’t be measured directly, and it changes over time—rising when demographic or technological changes improve the economic outlook, and falling when underlying prospects dim. If it has risen considerably over the past two years, it is plausible that the Fed hasn’t tightened monetary policy as severely as its dramatic rate-hike campaign would suggest.

“Scott Sumner, a monetary economist who recently retired from George Mason University, thinks that the natural rate has climbed sharply—pushed higher by the Fed’s monetary stimulus during the pandemic—muting the effects of the Fed’s 5-percentage points of rate increases over the last 18 months.

“’Most people would interpret higher rates as tighter policy, but you can’t necessarily jump to that conclusion,’ Sumner said. ‘If it were truly a tight monetary policy, I’d expect stocks to be depressed.’”

As always, we will continue to monitor the markets, but still recommend a long-term perspective with diversified allocations to stocks and bonds based on your specific financial situation.

One other important recent piece came from Jeff Sommer in The New York Times. He discusses the current attractiveness of bonds and cash, even as the stock market has made a strong recovery so far in 2023:

“Amid all the hoopla [surrounding a possible Artificial Intelligence-driven stock bull market], you can easily miss the solid returns being posted by far less glamorous but always important and, at the moment, compelling asset classes: fixed income investments, including bonds and cash.” [PPA note: The highest-yielding cash investments these days are referred to as “purchased” money markets funds.]

“Especially for those with short time horizons – whether you’re in retirement or close to it, or saving for a house, education, a car, a vacation or any other worthwhile purpose – those lower-risk investments are worth a close look. They provide solid income with much less risk than stocks – in theory, anyway.”

After a terrible 2022 for bonds, when prices declined in the range of 15%, “bonds are more reliable than they were last year because yields are already high. Even if they elevate further, there is a plush cushion now, and any potential price declines should be offset, and then some, by the income that bonds are generating.”

Please don’t hesitate to let us know if you’d like to discuss these or any other topics in additional detail.

To the surprise of many, the US debt ceiling issue was resolved relatively peacefully in the last week of May into early June. President Biden and House Speaker McCarthy worked out a deal that pleased few of the more extreme members of both political parties, but which raised the debt ceiling until early 2025 in exchange for modest spending cuts over the next year and a half.

Compromise like this is how government is supposed to work, and appears to offer glimmers of hope that the parties can work together to accomplish important (or at least existential) things. It’s a pretty low bar, unfortunately, but in light of the deep divisions across the country, we think represents at least some progress.

With that potential crisis out of the way for now, we return to the more substantive issues affecting the world economy and financial markets:

Inflation

Price increases continue to moderate in the US and worldwide as most central banks keep raising interest rates, or at least not cutting them yet. The Federal Reserve has raised rates ten times since 2022, and many observers think they might pause on the increases at their meeting later this month. But strong employment numbers and consumer spending in May could change that decision, either in June or later this year. It remains to be seen when the Fed will cut rates again if inflation persists.

Recession

If inflation does stay high and central bankers continue to increase interest rates, it’s possible that economic activity could slow enough in the US and elsewhere to produce recessions. Recent data appears inconclusive in the US, with employment and consumer spending holding up, as mentioned above, while manufacturing activity and housing, among other areas, slow.

“Investors are more concerned about whether the economy will fall into a recession before inflation recedes enough to convince the Federal Reserve to take it easier on interest rates.

“Reports Thursday (June 1) gave a mixed view. One said that fewer workers filed for unemployment benefits last week than expected, while another suggested employers increased their payrolls in May by more than forecast.

“That’s good news for workers and the overall economy, which has been slowing because of higher interest rates. But a strong job market could keep pressure up on inflation, pushing the Fed to keep rates high.

“On the flip side, manufacturing is continuing to get hit hard. A report from the Institute for Supply Management said manufacturing shrank for a seventh straight month in May” (Los Angeles Times, 06/01/23).

If a recession does happen, it could be short or long, with varying impacts on the stock and bond markets. As with all these issues, only time will tell.

Banks

An additional reason why the Fed might stop raising rates for now is the impact on the banking industry. Higher interest rates mean lower prices for existing bonds, and those lower prices have played a significant role in the recent failures of Silicon Valley Bank, First Republic Bank and Signature Bank. We haven’t heard of any other potential major failures of late, but that could change if rates continue to rise significantly.

In the context of all these potential problems, the stock and bond markets have continued to bounce back from the major declines of 2022. US stocks have risen 8.7% through May 31, with international stocks up 6.4%.

On June 6, the S&P 500 rose to a level 20% above the low point from October 2022, at the bottom of the recent bear market. This is a typical definition of the end of the bear market and the beginning of a potential new bull market.

The benchmark 10-year Treasury bond ended May at 3.64%, and US bonds have risen 3.1% for 2023 so far.

Are the markets performing with excessive optimism given the serious economic and financial challenges we still face? Or are the recent increases reasonable in light of ongoing progress in the battle against inflation?

As always, we’ll continue to monitor what happens and keep you informed. Please check in with your PPA advisor at any time if you have questions or concerns.