Money Talk: Investors face challenging stock and bond markets
The current environment is proving to be one of the most difficult for investors in recent memory. After years of solid stock market gains, including an impressive rebound from the pandemic-induced selloff. In 2021, stocks saw big gains fueled by the reopening of the global economy and low interest rates which triggered strong corporate profits. By the end of 2021, the S&P 500 Index had more than doubled from its March 2020 low.
Unfortunately, the tailwinds that pushed stocks higher have shifted. The low inflation environment that persisted for more than a decade has given way to price increases not seen in 40 years. Inflation has been exacerbated by both COVID-19 related supply chain issues and the boost in demand for goods and services triggered by the government's pandemic response. More cash in consumers' pockets would eventually lead to higher demand for goods which were now in short supply due to the pandemic. When demand outstrips supply, prices must rise. Add in an oil price hike triggered by Russia's invasion of Ukraine and you have an inflation picture that the Federal Reserve cannot ignore.
The Fed is following its playbook in pursuit of its dual objectives of maintaining high employment while keeping inflation in check by raising short-term interest rates and shrinking the money supply by letting the bonds it purchased during the pandemic fall off its balance sheet without being replaced. At its March meeting, the Federal Reserve raised the fed funds rate by one-quarter of a percent to 0.25%–0.50% and followed this with a half-percent increase at its May meeting. Its own Summary of Economic Projections suggests we may see a fed funds rate of 1.75%–2.00% by year end.
As a result, interest rates have risen substantially in the bond market, particularly on shorter-term bonds. This means returns on bonds have been negative in 2021. As of May 10, the Bloomberg Barclays Capital Aggregate Bond Index's return is just shy of negative 10%.
Most investors understand stocks do not move higher in a straight line. Periodic declines in stock prices are to be expected and are part of the reason stocks have higher expected returns. The higher return is an investor's payoff for tolerating the extra risk. The decline in bonds may be surprising, however, since interest rates have generally been on a downward trend over the past 40 years.
Investors in both the stock and bond markets make decisions based on expectations regarding economic factors like employment, profit growth and inflation. In the current environment, there is less confidence in those forecasts, which leads to market volatility. All eyes will remain on the Fed to see if they can implement a policy path that takes inflation out of the system without triggering a recession. For now, the economy appears to be on reasonably stable ground with employment continuing to show solid gains and consumer spending holding up well. If pandemic-related manufacturing shutdowns in China subside and the Russia-Ukraine situation can be resolved in the coming months, the Fed has a better chance of success.
What should investors do in such a challenging environment? Is going to cash until things improve a good strategy? Not likely. The problem with abandoning your investment strategy in favor of cash during volatile times is that, even if you avoid some of the downside, you are unlikely to feel comfortable getting back into the markets until after you have missed much of the upside. Remember that, while your investments are sitting in cash, inflation is eroding their purchasing power with no chance of ever getting that purchasing power back. A better approach is to evaluate your portfolio for rebalancing opportunities. Even if stocks and bonds have both declined, there may be some asset classes in your investment mix that have held up relatively well. For example, value stocks, particularly in energy, have held up well. It may be time to sell these to purchase shares that are now highly discounted. In bonds, shifting short-term holdings into floating rate notes may help as rates continue to rise. In addition, you may want to consider making some preparations for the next recession now that bonds are on sale. This means shifting into US Treasury bonds, preferably intermediate-term, as these securities will hold up well when the Fed eventually reverses course and again cuts rates to boost growth.
David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at 603-926-1775 or david@threebearings.com.
This article originally appeared on Portsmouth Herald: Money Talk: Investors face challenging stock and bond markets
