Active Bond Management – Reducing Risk
During the last several years we have shortened bond maturities across our bond portfolios. While this has meant lower income, it also meant our bond holdings were subject to much less interest rate risk when interest rates eventually rose. That eventuality has finally arrived as interest rates have risen substantially over the first part of this year. We are now purchasing bonds, both municipals and US Treasuries, with maturities of five years or less. We believe interest rates will continue to rise next year to reflect inflation and economic growth in the US economy. Since the start of January 2022, the iShares 3-7 Year Treasury Bond ETF (SYM: IEI) has declined -7.0%. The longer duration iShares 20+ Year Treasury Bond ETF (SYMB: TLT) has declined nearly -19%! This is why we have maintained short maturity date ranges for our portfolios, but we are now beginning to look at longer maturity and higher coupon bonds that provide higher income. We are not yet ready to implement our longer-term strategy, but the first step is in place as rates of risen. As we discussed previously, we will continue to ride the yield curve as interest rates rise.
We believe interest rates have already discounted most of the Federal Reserve’s short-term anticipated rate hikes. As the Fed increases interest rates, there will not be much additional increase in bond yields as yields appear to be stretched in the near term. We expect inflation to slow later this year as goods inflation slows due to supply chain and production improvements. We expect bond yields to remain near current levels until 2023.
The Fed has dropped its rhetoric that inflation is “transitory” and decided to fight it by shifting its monetary policy. The shift in Fed policy was a major inflection point for the markets and our economy. The first step was to discontinue quantitative easing through its ongoing purchases of $120 billion per month of Treasury bonds and mortgages, as well as adjusting interest rate policy through the Federal Funds Rate. Chairman Powell, raised the Fed Funds Rate by 50 basis points (a half percentage point) in early May. The market also expects another 50 basis point hike in June and potentially a 100 basis point hike or more, combined, over the remaining four meetings in the second half of the year. This is all in an effort to combat inflation which is running hot as reflected in the CPI data (Consumer Price Index) which excludes food and energy. Consumer prices are up 8.5% from a year ago, the largest increase since 1981.
China continues to battle COVID-19 with restrictive lockdown policies resulting in the closure of major manufacturing cities and Russia has continued its war on Ukraine both adding to inflationary pressures and making an already tall task for the Fed that much more challenging.
The recent stimulus due to both fiscal and monetary policy added about 30% to our money supply. If the government increases the supply of money by 30%, then prices could rise by 30%. It’s an oversimplification but is generally true. Previous periods of quantitative easing were done primarily within the commercial banking community but the most recent stimulus went directly to the public. “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” – Milton Freidman
Recession Fears Rise
All major stock indices are in correction territory. A correction is usually defined as a 10.00% decline in the price of a security or index from its most recent peak. Keep in mind, that prior to 2020, there were 26 market corrections since World War II, as measured by the S&P 500 Index, with an average decline of 13.7%, according to Goldman Sachs and CNBC. The average recovery period was approximately four months.
Companies continue to report first quarter earnings results and for much of the market, they have been relatively positive. Despite many quality earnings reports, stocks sold off in April as bond yields rose increasing fears of a slowdown in global growth. Many stocks started the year at valuations above their historical averages, as interest rates rise it is not unexpected for there to be some compression in stock multiples. Unprofitable growth stocks, briefly the darlings of 2021 have declined substantially this year, with some companies down 60%-70% off their highs.
As markets have corrected, fears of a near-term recession have grown. Recessions are inevitable and necessary to a healthy and growing economy. They purge the system of excesses and unproductive assets when left of the will of a free market. The Great Recession of 2008 purged the markets of overleveraged banks and overleveraged consumers. It has taken over 10 years for both groups to become “healthy” and rebuild their balance sheets. The 2020 recession was government-mandated to deal with COVID-19. Between the last two recessions, the private sector has rebuilt and recovered from its earlier excesses. Today’s excesses are in government spending and because of their nature, will be difficult to purge.
The Fed’s fight to reduce inflation could induce a recession depending on the speed and size of the interest rate increases. Previous inflation-fighting efforts have created recessions, higher unemployment, lower asset prices. The goods news is the markets respond very quickly to recession by declining sharply and recovering quickly too! The Fed, administration, business, and workers all are disadvantaged by recession, therefore recessions are met with aggressive government stimulus to keep them as short and painless as possible. We are not currently predicting a recession but the probability of one has certainly increased.
Trying to time a market sell-off and then repurchase before prices appreciate again has always been elusive for all investors. Even though uncomfortable, it has proven to be better to be a long-term investor and add to your portfolio during periods of market weakness and manage portfolio risk during elevated periods of volatility.
Chart of the Month – Help Wanted! Job Openings Top 11 Million
The US economy continues to be strong as evidenced by a low unemployment rate of 3.5% and strong labor demand. A tight labor market does add to inflationary pressures but if you want a job, you can find one!