It has been a good long run for stocks. In recent years, they have benefitted from historically high corporate after-tax profit margins, historically low-interest rates, aggressive share repurchasing programs, and the low cost of money. The term “priced for perfection” is apt.
However, several factors have recently combined to create the highest inflation levels in decades: a pullback from globalization, loose monetary policies, and commodity and supply chain disruptions. In response, the Federal Reserve crafted a prescription and has begun to administer the medicine: higher interest rates.
A Tough Pill to Swallow
Unfortunately, higher interest rates is a medicine that comes with side effects. As money becomes more expensive, economic growth can slow, security valuations are often reduced, and uncertainty rises. We are seeing all of this now.
In addition, the current level and pace of inflation are turning out to be more severe than what most economists and Fed officials expected. This is not a garden-variety inflationary event, and the medicine is proving to be a tough pill to swallow.
The first quarter of 2022 jolted everyone awake. US stocks and bonds both fell. Some growth stocks saw the value of their companies drop by over 50%. And after declining -1.3% in 2021, investment grade bonds fell another -5.9%.
This first quarter decline in stocks and bonds is quite rare. Since 1965, stocks have tended to rise with interest rates, so long as the 10-year Treasury rate was below 3.6%.1 The 10-year US Treasury bond was 1.5% on Dec 30, 2021 and is yielding 2.7% today. Yet stocks have declined.
Investment grade bonds have fared no better. 2021 was a down year, and Q1 of 2022 saw them drop further. They have not posted back-to-back negative years since 1958-59, and the first quarter of 2022 was their second worst loss ever.
If the current decline in both stocks and bonds persists for the entire year, it will only be the fourth time this has occurred in 93 years. The other three times were in 1931 due to a currency crisis; in 1941 during World War II; and in 1969, a year that saw loose monetary policy, generous fiscal stimulus, and energy supply disruptions.2
The 1969 scenario is the closest to our circumstances today. In terms of the fiscal stimulus component, Jamie Dimon, CEO of JP Morgan Chase, the nation’s biggest bank, recently wrote that “In hindsight, the medicine…was probably too much and lasted too long,”3 referring to the various programs and trillions of dollars used over the past two years to mitigate economic risks from the pandemic. Compounding this, the increase in money supply has been joined by rising commodity prices stemming from a war among commodity suppliers and ongoing supply chain disruptions. All of these weigh on stock prices.
Despite the bad news from Q1 of 2022, there are three key items to keep in mind. First, portfolio income derived from stock dividends and bond coupons has remained the same, or even risen. So, despite a decline in stock and bond prices in Q1, portfolio income has remained stable. This is extremely important for investors who rely on portfolio income for a portion of their living expenses.
Second, when discussing whether near-term economic factors will result in a stock and bond portfolio value declining further, we are talking about relatively short-term scenarios. Balanced portfolios of stocks and bonds can sometimes lose money in a single year, or even for several years, but they have never posted a negative return over 10 years. Long-range planning and a proper asset allocation mix will result in good outcomes.
Third, securities markets typically react quickly to new information and re-price as actual events unfold. This is holding true now with the proposed Fed rate hikes. The market has already moved ahead of any actual Fed action and priced in much of the interest rate increases planned for 2022 and 2023. This means that any signs of an economic slowdown or other unexpected news that causes the Fed to pause their rate hikes, or even stop monetary belt-tightening, could result in both stocks and bonds rallying together.
Summary & Actions
Rising interest rates are often associated with economic growth, but markets had grown accustomed to a zero interest rate and loose monetary policy environment, which resulted in securities of many asset classes being priced at extreme multiples and all-time highs. As we move from a market priced for perfection to one that has become overheated and needs cooling down, we will continue to experience volatile price shifts. Federal actions and supply chain repairs will dictate just how volatile and just how far down prices might go.
A successful series of interest rate increases would create a “soft landing” for the economy. But persistent and rapidly rising inflation create a tough scenario for the Federal Reserve, which is seeking to both reduce inflation and keep the economy humming along.
The current uncertainties and potential for further portfolio declines are most important for allocations with shorter time horizons, especially money that is needed for living within the next three years. Most of the time, it is best to meet uncertainty with steely-eyed resolve and trust the portfolio allocation to do its job. And, when given the opportunity, to purchase stocks after a large decline by rebalancing back to a pre-determined allocation mix. The latter action is best and mentally easiest when the portfolio begins any decline with a reasonable amount of bonds and an appropriate level of risk is taken.
In closing, inflation is front and center. It impacts everyone. As discussed last quarter, it is not a single number: each of us has our own personal inflation rate, and for some it is far worse than for others. For corporations, it could mean lower profits and margins, and for consumers it will mean a rise in prices and cost of living.
The bottom line, however, is that any short-term investment price pain we are experiencing from rising interest rates is far better than the lingering impacts of high inflation. If an illness is left untreated, it can be deadly, and medication must be administered skillfully. If the Fed is successful, we can reduce inflation rates while seeing a soft landing in investment markets.