As we head into the fourth quarter, there is a lot to unpack as political dysfunction and an onslaught of bad news dominate headlines. While political battles are often noise, the next looming budget fight is less than six weeks out and could affect global equity markets if it devolves into a shutdown. U.S. debt could be downgraded, and global bond and stock markets could be subject to sell-offs. Couple this background with negative returns on most investments in September. Interestingly enough, September has historically averaged the worst returns of any month, and this year was no exception, with the S&P 500 dropping 4.9% and the red-hot NASDAQ down 5.8%. The Dow Jones Industrial Average turned negative for the year this week. The UAW strike continues, which could lead to more widespread layoffs, and the office real estate market could be on the verge of imploding with workers continuing to work remotely. Mortgage rates have soared to levels not seen since 2002.
AND YET…
The U.S. economy continues to be resilient, and investment opportunities will shift in the sea of bad news. We want to walk through some overarching themes.
- Federal Reserve tightening will slow economic growth and likely shift investment opportunities to fixed-income and defensive sectors (health care, insurance, consumer staples)
- The United States is not in a recession, but the likelihood of a “soft landing” is decreasing
- Mortgage rates are affecting the housing market, but demand for new homes continues to be relatively strong, particularly for older buyers who are increasingly paying cash
Fixed Income
Individuals and companies with cash (personal and corporate balance sheets continue to be in good shape in the aggregate) can now earn around 5% investing in money market funds and CDs. However, rising interest rates also cause the prices of existing bonds to decline. Gains in bond funds experienced earlier this year have been reduced or wiped out with the recent rise in interest rates. However, it is nowhere near as bad as last year’s rout in what is generally considered a relatively safe asset class. We see continued developing opportunities to earn 2.5% to 3.5% above inflation over the next 3-5 years. So, let’s again walk through the math on how rising interest rates affect bond investments.
Suppose you bought a U.S. government-backed bond 18 months ago, maturing in 20 years. The price has dropped almost 50%! Mind you, this is a security backed by the US Government where you will get regular interest payments and be paid back 100% of your money at maturity. The price drop corresponds to your bond being locked into paying 3% per year, whereas a new investor can buy a new bond paying 5% per year. The longer until the bond maturity, the greater the price loss for a given interest rate increase.
When interest rates are at or near their peak, bonds become very attractive because you lock in the higher yield for longer. While money market rates tend to decline, you still get the higher yield, and the opposite effect occurs with prices on existing bonds: the prices increase. The timing does not have to be perfect. Even if inflation is higher for longer, the bond market has reacted to that reality, and potential returns are attractive, particularly in a weak stock market. Our fixed-income charts show the current move in interest rates to new highs across both short and intermediate-term bonds. Current yields are attractive relative to inflation, perhaps more so than we have seen over the last 16 years. Yet, we are likely close to or above rates we would historically expect relative to inflation. This is likely a good investing opportunity.
Continuing with the same theme, we calculated the chart showing the difference between current mortgage and bond rates. That difference (the spread between the rates) is historically high. While not good for house purchasers, as investors, this spread becomes an opportunity and is another indicator for investing in fixed income, including bonds, instead of solely sticking to money markets and CDs.
30 Yr Mortgage Rage vs. 10 Yr Treasury Rate
Equity Markets
Below, we show charts of the S&P 500 (SPY), NASDAQ (QQQ), Consumer Staples Sector (XLP), and Healthcare Sector (XLV). You can see that both the broad indices and defensive sectors are still significantly below the highs from 2021. This is despite the robust returns from large tech companies that have driven S&P 500 and NASDAQ returns this year. Most of those returns were only a recovery from the 2022 sell-off. With fixed income returns increasing, the growth areas of the market may become less attractive to investors, and we may also start to see a shift towards more defensive sectors, much like what happened in early 2022.
S&P 500 EFT (SPY)
NASDAQ (QQQ)
Consumer Staples Sector (XLP)
Healthcare Sector (XLV)
Conclusion
The stock market has had negative returns over the past 20 months. However, during that time, there have been several periods where certain sectors have done very well versus others. The problem is that those sectors have not sustained the gains. With growing earnings and sales, certain sectors, still selling below their 2021 highs, are reaching very attractive prices relative to earnings. With interest rates higher, bonds are looking like bargains. We will continue to adjust portfolios this quarter as opportunities change and perform some tax-loss harvesting as we head into year-end. If we get through the current turmoil without a breakdown in stock prices, we would not be surprised to see a year-end rally. If markets fall apart, we will reduce equity exposure.
Speaking of Taxes
We will produce year-to-date income and capital gains/losses reports for tax planning. Let us know if you need to have these sent to your accountants for year-end planning and estimated tax payments. Dividend income will be substantially higher relative to 2022 in most accounts due to increases in interest rates.