Financial Markets and the Economy
Stock markets declined in the 3rd quarter of 2022. In the U.S., the S&P 500 was down 4.9% in the 3rd quarter, and down 23.9% year to date. Globally, the MSCI EAFE was down 9.4% in the 3rd quarter and down 27.9% year to date. Small company indexes were down. The Russell 2000 was down 2.2% for the quarter, and down 25.1% year to date. Treasury yields rose as the 10-year U.S. treasury bond was yielding 3.8% at the end of September from a yield of 1.5% at the end of 2021. Continued rising interest rates led to further declines in bond indexes. The Bloomberg US aggregate bond index declined 4.7% for the quarter and is down 14.6% year to date.
There are certainly plenty of concerns for stock investors that have resulted in the declines in stocks we have experienced; a worsening military conflict, spotty global energy inventories and an increasing number of regions around the globe falling into recession. On top of these issues is the overarching concern of global inflation and rising interest rates. After almost 15 years of a US policy of rescuing every downturn in the economy and the financial markets by printing massive amounts of money and pushing interest rates to zero, an inevitable bout of price inflation has started.
The US Federal Reserve now has belatedly changed course and is in inflation fighting mode, aggressively raising interest rates. Even if there was no price inflation, it was an eventuality that interest rates would need to rise from zero to a more normalized market driven level. On top of that, there is now an urgency to tamp down inflation. Other periods of inflation have shown that if not dealt with in a strong manner, expectations of rising prices can fuel a wage-price spiral that is increasingly difficult to tame. The 1970s decade was the last severe bout of price inflation with a run-away wage-price spiral. By the peak of that period, we saw a 20% federal funds rate, a 16% 30-year mortgage rate and one-year CDs at double digit interest rates.
For context, currently the 30-year mortgage is over 6% (up from 2% to 3% a year ago). The US Federal Reserve has signaled to the market that they plan to raise rates higher and will do so until inflation is subdued. An analogy to this fight is every gardener’s plight. If you pull a weed just after it gets started it comes out easily, root and all. If the weed is allowed to grow for too long it’s hard to pull out and if the root breaks off, well, it’s coming back! It seems clear that the US Federal reserve will likely be aggressive in not allowing this run of price inflation to take root. This is a difficult task for the Federal Reserve to carry out. Typically, the outcome is a slower economy or recession, higher unemployment, and lower profits for companies. The stock market has been discounting this outlook and usually stops going down before there is evidence the economy has bottomed.
Investing in this climate is challenging to say the least. The benchmark portfolio of 60% equity/40% fixed income was down 21% or more this year(1). It is the worst performance for that allocation since 1936. While stocks will over time have severe corrections, the 40% fixed income allocation is the real culprit in this once in almost 100-year occurrence. Seasoned bond managers say they don’t remember a negative year for bonds like the numbers we have cited above. This price drop was the inevitable result of interest rates rising from zero and bond prices falling in lock step. Being wary of this possibility, for some years now we have kept the maturities of client’s bond portfolios relatively short. Any portfolio with shorter duration fixed income has fared better than the broad fixed income benchmarks in this rising rate environment.
We don’t want to sugarcoat overall performance; doing “less bad” in a severe decline is a gut-wrenching affair. We know this has been a disconcerting time for all investors and sometimes it feels like we get blown off course. We are here to help make sure you stay on course for the next waypoint, and all the waypoints thereafter.
With interest rates at levels we haven’t seen in over a decade, and continued upward pressure, we wanted to speak to a few related planning items.
All forms of financing are now more expensive, so holding onto those mortgages or other loans secured in the past several years with fixed rates will look more attractive. Unless you emotionally don’t like the idea of holding debt, holding onto these lower rate loans, and taking the full term to pay them off can make good financial sense.
Alternatively, using financing on new purchases will require more thought and analysis. Depending on your overall liquidity and cash flow situation, paying all cash, or making a larger down payment for larger purchases may now be a better way to go. Along the same lines, any variable rate mortgages or financing should be monitored to determine whether continuing to hold is prudent.
As interest rates continue to rise, it is also important to monitor cash levels in bank checking and savings accounts. Not that long ago holding larger balances in a bank checking or savings account earning 0% was par for the course. Now even the daily liquid FDIC Insured online savings banks that compete for business are paying over 2%. This interest can add up, and in this environment every extra dollar counts! We encourage you to spend some time with us talking through the time horizon of your cash and consider the best options for maximizing your income.
Rising interest rates will also have an impact on permanent life insurance policies and annuity products. Depending on the design and structure of an individual policy, higher rates could have a positive or negative effect on your cash value and long-term performance of the policy. The best way to confirm this is to get an updated illustration from the life insurance carrier based on current rates and assumptions. We can help with this and now would be a good time to complete a thorough review and determine whether any action should be taken to ensure what you have still meets your objectives and is managed as efficiently as possible.
As you have come to understand, we love to spend time on cash flow planning. During our cash flow modeling reviews, you may have heard us use the phrase “garbage in, garbage out.” This just means the outputs from the analysis are only as good as the inputs and assumptions built into the model. We always pay attention to the inputs and do our best to “truth check” them against what we see from a portfolio cash flow perspective, but as inflation rises it will be important to revisit these inputs together and make any adjustments necessary.
As always planning should start with your high-level goals and objectives in mind and we’re here to help your family stay on course! Please do not hesitate to reach out as you have questions or concerns related to your portfolio, planning, or anything else.
Waypoint Capital Advisors
(1) Based on a portfolio of 60% MSCI ACWI Index and 40% Bloomberg US Aggregate Bond Index, rebalanced monthly.