“Anyone who isn’t confused really doesn’t understand the situation.” – Edward R. Murrow
It is different this time – the five most dangerous words in investing. As we reach the final quarter of the year, there is a rational case to be made that, in fact, it may be different this time.
Howard Marks recently wrote a memo suggesting we are in the midst of a “sea change” after a forty-year-plus period of declining interest rates. More pointedly concerning the post-financial crisis period, he writes, ”The overarching theme of my sea-change thinking is that largely thanks to highly accommodative monetary policy, we went through unusually easy times in a number of important regards over a prolonged period, but that time is over.”
Consistent with this thinking, we have written in recent commentaries about a return to a more normal environment, and the third quarter continued along this path. While investors tend to focus on equity markets, the real “action” in the third quarter was found in the bond markets with meaningful implications for investors. As I write this commentary, US Treasury yields are approaching 5% for the first time since 2007, while mortgage rates over 7% represent the highest level since 2000.
While we are not classically trained economists, we subscribe to the view that financial market returns and risk ultimately depend upon a directional perspective on the economy. At a high level, our economy has been surprisingly resilient in the face of rising rates, supporting stable earnings and, thus, equity markets. When we peel back the surface, however, the picture is less positive, with significant pockets of weakness (i.e., housing) and strength (i.e., capital spending, employment).
The equity markets paint a bifurcated picture with a small group of mega-cap businesses, the Magnificent Seven*, generating strong earnings growth and stock price performance. The balance of the market, as measured by the S&P 500 equal weight index or the Russell 200 small cap index, is down year to date. That is the view through the rear-view mirror; the path forward is what matters for equity investors. And that path requires accelerating earnings to validate current growth expectations and extended valuations – a high bar in the face of higher rates, moderating fiscal stimulus, and falling excess savings on consumer balance sheets. Pulling it all together, we subscribe to muted return expectations for equities. Our portfolio will continue to emphasize businesses we believe have favorable long-term fundamentals with reasonable valuations.
However, the “action” is found with fixed income and credit.
Interest rate volatility has accelerated over the last three months, potentially destabilizing the economy and equity markets. “Higher for longer” now appears to be the consensus view with implications for debtors and savers. For investors, fixed income has failed to preserve capital and generate income over the last three years. Using the Ishares 20+ Year Treasury Bond ETF (TLT) as a proxy, investors in long-dated US Treasuries have experienced a 52% decline in value, a similar drawdown to the stock decline during the Great Financial Crisis. The decision to hold shorter-dated maturities in fixed income has effectively preserved capital while allowing portfolios to take advantage of rising rates. Again, that is the view through the rear-view mirror.
The path forward, in fact, looks brighter for fixed income investors. The opportunity to earn an annualized return of 5% or greater in investment grade bonds has material implications for asset allocation. Headlines suggesting the “60/40 balanced portfolio is dead” may need to be revised. While lower interest rates forced investors to take additional risk to achieve required returns, the corollary is also true. Similarly, potential returns in credit investments may hold the potential to earn equity like returns at lower levels of risk.
In an uncertain environment where risk appears elevated, even before we add in a challenging geopolitical backdrop, we will continue to position portfolios to manage risk while patiently looking for opportunities to take advantage of higher rates.
Please do not hesitate to contact your wealth advisor or a member of the Investment Advisory team with any questions.
