Bonds On Center Stage
Bonds usually appear to play a supporting role in market events, while growth stocks and cryptocurrencies catch the spotlight. But the size of the bond market and the importance of its role in providing financing for growth cannot be underestimated. When there is a change in the bond market it is reflected in all other assets (i.e., stocks, real estate, commodities). Interest rates hit record lows during the COVID-related economic shutdowns of 2020 and bond prices reached record high levels at the same time. Since that low point, interest rates slowly increased in early 2021 and accelerated through the end of the year as oil and inflation both rose, unsettling stock and bond markets.
In the chart to the right compares you can see the steep rise in yields on the “short-end” of the curve and how the curve has now flattened.
As we started 2022, the U.S. 2-yr. Treasury note yielded 0.79% in January, up from the 0.17% low yield seen in 2020. At the end of the first quarter, the U.S. 2-yr. Treasury had risen to about 2.42%! During that same time period, the 10-yr. Treasury was yielding 1.63% in January, and today it yields 2.53%. The direction and intensity of these changes in market fundamentals have surprised and unsettled all the markets adding to volatility.
Can the Fed Engineer a “Soft Landing”?
The Federal Reserve has backed itself into a difficult corner as it relates to normalizing monetary policy. The Fed used two primary tools to support the economy during the pandemic, first, they moved the Federal Funds Rate to zero pushing down interest rates and second, they expanded their balance sheet through quantitative easing. In fact, the Fed increased its balance sheet by over $4.5 trillion to support government borrowing and spending in an attempt to offset the economic losses due to lockdowns.
As a result of these policy decisions, the money supply has increased by more than 40% since February of 2020. Simply put, a great deal of spending was paid for out of thin air. As the world continues to recover from the pandemic, the Fed must face the tough fact that inflation, once believed to be “transitory” is in fact persistent. Chairman Powell and the Fed realize they are far behind the curve when it comes to normalizing interest rate policy and must aggressively move to contain inflation with the added challenge of not flat-lining a recovering economy. Markets and investors understand that this is no small task and this has been reflected in market volatility in both stocks and bonds.
With that said, the Fed has started its quest to contain inflation by raising the Federal Funds rate by 0.25% in March. Chairman Powell expects to contain inflation over the next 3 years through a continued series of rate hikes. The Fed will increase rates until it gets a favorable response from the economy (i.e., inflation recedes). Unfortunately, the Fed always goes too far and starts too late because there is approximately a six-month lag between the increase in interest rates, the restriction of credit, and the resulting effect reflected in the economy.
The Fed also announced it will begin to reduce the size of its balance sheet. A reduction in the size of the Fed’s balance sheet is considered “quantitative tightening” (QT). The Fed has announced that the pace of QT will be faster than it was in 2018-2019 which was $50 billion per month. QT should put upward pressure on longer-duration bond yields, thus resulting in a steepening of the yield curve.
European Equities Look Attractive
Global equities, primarily Europe, should be the best performing group as all global economies continue to recover from COVID-related restrictions and supply chain problems. European stocks offer attractive valuations and are less expensive when compared to U.S. equities. We have added additional European equity exposure across all equity portfolios. We do expect continued volatility due to the ongoing war in Ukraine, but talks of a cease-fire or any resolution to the conflict will be positive for European equities.
Although the war in Ukraine has added to the oil and natural gas problems in Europe, the conflict is not the main cause of higher prices. As the U.S. economy continues its recovery from the pandemic, growth is expected to accelerate later this year. Strong demand has paved the way for higher prices.
Job Market Growth
Nonfarm payrolls increased by 431,000 in March and payroll gains for January and February were revised up by a total of 95,000, bringing the net gain, including revisions, to 526,000. The private sector payrolls rose 426,000 in March and revised up an additional 129,000 in prior months. The largest increases in March were for leisure & hospitality (+112,000), professional & business services (+102,000, including temps), education & health services (+53,000), retail (+49,000), and manufacturing (+38,000). The Government increased by 5,000. The unemployment rate fell to 3.6% in March from 3.8% in February.
While there are signs of optimism with positive job growth and upward payroll revisions the job report was not all good news. The labor force participation rate (workers who are either working or looking for work) is still below the pre-COVID rate. Additionally, while workers’ wages and earnings are increasing, they are not keeping up with the current level of inflation.
Thoughts on Interest Rates and Inflation
Since 1982 interest rates have been declining, until 2020 when over 20% of the world’s government bonds had a nominal negative yield! Common thinking is that inflation, low growth, and low-interest rates are the norm. There is lots of evidence to support the low growth theory because of high debt-to-GDP levels and massive government spending. Many institutional investors have been reluctant to believe that inflation is permanent and therefore an interest rate will rise will be temporary. Currently, inflation is running over 7.0% and 10-yr. bonds are yielding 2.7%. This creates a negative real rate of 4.5%! The Fed could surprise the markets by increasing interest rates over the rate of inflation but for now, this scenario remains unlikely. Our view is that inflation will be sustainably higher than currently reflected in the markets and is increasing a bond market adjustment that in turn is being reflected temporarily in all assets.
We are not expecting a 1970’s or early 1980s style inflation scenario, but a 3.0% or higher rate with sticky wages and rental inflation. These will keep pressure on inflation and higher interest rate levels until the next economic slowdown. These changes create opportunities for investors to take advantage of change. We will use these opportunities to your advantage and ours. As you know, we invest our money right alongside of our clients and own what you own. We buy and sell stocks and bonds at the same time and at the same price as yours.
The Securing a Strong Retirement Act AKA SECURE ACT 2.0
The House of Representatives recently passed “The Securing a Strong Retirement Act” which is also being referred to as the Secure Act 2.0. Back in 2019, the original Secure Act was passed which resulted in the Required Minimum Distribution age being raised to 72 from 70½. The Secure Act 2.0 looks to add additional provisions to better prepare for retirement. Some of the key provisions of the bill that now moves to the Senate include:
● Raising the age for required minimum distributions, or RMDs, from their retirement savings accounts to 73 from 72, effective next Jan. 1. The bill will raise the age to 74 starting in 2030 and to 75 starting in 2033.
● For 401(k) and 403(b) plans, there will be increased limits on catch-up contributions for employees ages 62 to 64. In 2021, these workers were allowed to contribute up to $6,500 to their retirement savings plans beyond the otherwise applicable limits. This bill increases that limit to $10,000, beginning in 2024, and indexes it to inflation.
● Expanding automatic enrollment of workers in employer-sponsored retirement plans. Beginning in 2024, employees would be automatically enrolled in plans such as 401(k)s and 403(b)s unless they opt-out.
● Creating an online, searchable “retirement savings lost-and-found database” at the Labor Department to help workers and retirees find their lost retirement accounts, including those from previous employers.
As with any new form of legislation, there will likely be adjustments before the final bill is passed. We will update you with additional information once the bill is signed into law.
We are of the opinion that the varying contribution limits for different retirement plan types are very inequitable. Larger companies can afford to offer more expensive 401(k) retirement plans which allow for much higher contribution limits when compared to SIMPLE IRA plans or IRA contributions. The cost to administer a 401(k) plan is often a barrier for small businesses. Workers at these small businesses often perform the same jobs but are limited to lower retirement plan contribution limits. This provides a huge advantage for larger companies in retaining and attracting talent and unfortunately adds to the growing retirement crisis.