MARKETS AND THE FED
Markets rallied in October as investors became hopeful that the Federal Reserve would soon pivot and change its monetary policy approach. However, during the most recent FOMC meeting, Chairman Jerome Powell again increased the federal funds rate by an additional 0.75%. This was the fourth consecutive increase of that magnitude. In his press conference, Chairman Powell signaled that the Fed could slow the pace of future rate increases but made it clear that this change was not the “dovish pivot” the markets have been hoping for. He said a more moderate pace of rate hikes is called for due to slower growth and tighter financial conditions. He went on to say that the recent speculation of an imminent pause is “very premature.” We expect the Fed terminal rate will be over 5% when clear signs of the sustained, softer labor market are present. Powell restated his conviction to reduce inflation and hold rates higher for longer to ensure no future resurgence in inflation occurs.
Stocks are reporting third-quarter earnings, and companies that come in below estimates or have given weaker forward earning guidance have seen their shares sharply reduced in price. Nevertheless, oversold stocks and bonds still have room for a year-end bounce, but it is too early to expect an imminent sustainable bottom. We expect market volatility to persist in the near term. To put into context the level of volatility seen in the markets, as of October 25th, the Dow has surged +400 points 34 times this year. In the decade-long 2010-2019 bull market, there were only 21 such moves (Rosenberg Research). During bear markets, you can see dramatic “short-covering rallies,” which lead to stocks being squeezed and prices moving higher.
We continue to do tax loss harvesting for stocks and bonds, maintaining high-quality companies and the highest-quality bonds. As rates continue to rise, we are beginning to extend bond maturities to lock in higher income and expect appreciation when inflation is reduced.
POLICY FALLOUT
The US economy has given clear signals of slowing, as reflected in slower real estate sales, weakening home prices, lower auto sales, and higher credit card usage as consumer savings diminish and prices continue to rise. Our current inflation issues stem from a historically long period of low- interest rate policy and a massive amount of government spending and stimulus, the likes of which have not been seen since WWII. Trillions of dollars have been spent on various government programs, and at the same time tighter restrictions were placed on the energy industry, specifically oil and gas production on federal lands, thus exacerbating inflationary pressures. Both the White House and the Federal Reserve are saying they want to curtail inflation, but outside of demand destruction, the cure for inflation is less borrowing and spending, and one of them has not been willing to try. These are concerning issues as many Americans are experiencing the worst cost of living crisis in decades. Real incomes adjusted for inflation have dropped at the fastest pace since the inflation of the 1980s. Not since the Carter administration have Americans experienced this type of inflation, and it is very difficult to put the inflation genie back in the bottle, getting back to 2% inflation will be painful. This debt fueled spending spree has not been necessary, because the economy was already recovering! Consumers have been under considerable pressure and consumer sentiment has fallen to lows not seen since 1952. The good news is it appears inflation is showing signs of peaking, which is one of the reasons why treasury bonds are yielding 4% instead of the recent inflation reading of about 8%. However, 2% is not in sight, and that is why the Fed will need to keep interest rates elevated for an extended period of time.
QUALITY MATTERS
Quality matters in most things such, as education, healthcare, machinery, and appliances, but also when it comes to investments. One area in which quality matters is bonds. Bond quality ratings are specified by a few investment rating services such as, Moody’s, Standard & Poor’s and Fitch. They all rate bonds on a similar scale with “AAA” signifying the highest quality bonds, down to “D” the lowest quality bonds.
In recent years, interest rates have been extremely low, enticing savers that were searching for income to buy lower quality bond funds and bond ETF’s. These “higher yielding” bonds funds are also known as “junk bond funds” because the majority of the portfolio consists of low-quality, or less than investments grade bonds. The yield on these bonds is higher because the risk of non-repayment of principal and interest is higher. Bond Ratings below an investment grade of BBB are considered “junk.” In the universe of junk bonds there is an average annual default rate of about 4% during normal economic times, so the income must be higher than 4% to break even on a portfolio of say, 100 different junk bonds. During times of stress or recession, the default rate can climb to over 12%! Remember these are highly leveraged or indebted companies, and a slowdown in the company’s income will have a disproportionately adverse effect on income available to make interest payments and retire bonds that mature.
When interest rates rise bond prices decline temporarily. The decline in prices reflects higher interest rates available in the market, the temporary part is because there is a due date when the bonds mature and regardless of what the level of interest rates in the market at the time are, the bond principal will be paid in full by issuing company. For companies that issue junk bonds, they may not be able to pay off their bonds when the maturity date arrives, and they can default on their obligation. During a recession is when we see the default rate climb from 4% to 12% on average. The exception was during the pandemic-related recession of 2020 when the Federal Reserve added junk bonds to its balance sheet in an effort to prevent a financial disaster. These junk bonds have replaced investment-grade bonds as a source of income because the interest rates were so much higher. Unfortunately, many participants in 401k plans, do-it yourself investors and clients of non-fiduciary advisors have invested billions of dollars of their savings in junk bonds not fully understanding the level of risk they were taking.
A word of caution! Long-term investors in junk bond funds and ETFs could face a serious decline in their principal over time. The cumulative impact of annual defaults will affect the principal of the fund if all of the income is distributed. These bond portfolios will reflect changes in interest rates and different stages of the business cycle. Therefore, they are best used for trading not investment purposes.
If you have friends or family who own junk bonds funds or ETFs, encourage them to review their 401k’s and investment portfolios for these funds and their ratings. If we can be of service to help with the evaluation or review process, have them contact us at ryanm@pacificcoastia.com or call. These funds and ETFs are not worth the risk.