CASH AND TREASURY BILLS
We shifted portfolios to be more defensive during 2021 and that has continued throughout this year. As part of that defensive positioning, we have had an outsized position in cash, which we placed in T bills to generate some income. When we started to increase our cash position, money market funds and bank savings accounts yielded 0.01%, while our cash was earning over 1%! As the T-bills matured, and the short-end of the yield curve steepened due to the Federal Reserve raising short-term interest rates we continued to buy T-bills, riding rates higher. Today our cash balances are earning over 3% while money markets funds and banks savings accounts are yielding 0.25%.
There has been a great deal of uncertainty and volatility in the markets due the Federal Reserve raising interest rates to combat inflation which we have discussed throughout the year. By increasing the cash weighting in the portfolios, we have been able to reduce volatility in the portfolios.
The bond market has rocked the financial world this year as much if not more than the stock markets. Bond investors and central bankers incorrectly believed that inflation was “transitory” and were caught off guard when it did not recede. As inflation reached its highest levels in the last 40 years, the Fed and other major central banks have been trying to play catch up as they found themselves far behind the yield curve after years of low interest rate policies. Just this past month the Fed signed off on its third consecutive 0.75-point rate hike, lifting the benchmark federal funds rate to a range of 3-3.25%. No other hiking cycle has started this steeply since the 1980s. Historically, both the amount of the interest rate increases, and the pace of the rate hikes has been very aggressive for the Fed which has unsettled markets.
The Fed now expects to have the fed funds rate at 4.40%. It is assumed by Fed officials that the “neutral rate” is 2.5%. A neutral rate means that monetary policy is neither stimulating nor restricting economic growth and would allow the Fed to achieve its dual mandate for stable prices and full employment. Once rates rise above the neutral rate, the Fed believes rates are no longer stimulating the U.S. economy but instead, they’re actively slowing economic activity down. The “neutral rate” was 3.75-4% just a few years ago and we think that is where the target should be now. Treasury bonds are already in that range as of last week, so we expect that in order to contain and reduce inflation the Fed will have to continue to increase rates.
Bond Funds Suffer in a Raising Rate Environment
While an individual bond has a periodic, fixed payment and a stated maturity date at which principal is repaid, bond funds operate in perpetuity and pay dividends that fluctuate over time. This means bond fund buyers have no way of knowing what total return they might receive in any given period. As interest rates rise and time passes, bond funds will buy bonds at lower rates (higher prices) than when they sell them, sometime later, at higher rates (i.e at lower prices). Meaning, bond funds are forced to buy high and sell low. With the Fed in a rate-hiking mission, bond funds are doomed to continue to lose money. This is a key reason why we have favored investing in individual bonds for clients, specifically US Treasuries. Additionally, the majority of bonds held in client accounts mature within the next one-to-three years which means by keeping the bond maturity on the short-end of the yield curve, the bonds are much less impacted by interest rate risk and therefore have done much better when compared to a popular bond index such as the Bloomberg US Aggregate noted in the table above.
Risk of Rising Rates – A Global Issue
What can go wrong in a rising rate environment? Well, last week the U.K. reversed course and started buying bonds to reverse the slide in Gilt (U.K. government bonds) prices. This historic intervention by the government to restore financial stability came after panic hit the countries pension funds, with some of the bonds held within them losing around half their value in a matter of days. There are concerns regarding Britain, Canada, and Australia as all are highly leveraged countries with greatly over-extended real estate prices and over-leveraged consumers. The recent increase in interest rates are beginning to express the weakness and leverage in these and other economies. This may be a source of global risk if there is forced liquidation in those countries and warrants monitoring. This is what the recent U.K. bond rout and emergency intervention and global bond rally was about. You would think they would have learned for the banking and real estate collapse of 2008, but they didn’t!
We have been warning clients for many years not to buy annuities, junk bonds, and longterm bonds. In a world where negative real interest rates were reflected in up to 30% of the worlds bonds, that created an environment that was not investor friendly and this warranted consideration before buying these assets. We warned about annuities and insurance contracts because investors
risk not only losing the principal through “annuitizing” a contract but also locking in low reinvestment rates, coupled with high expenses. We also maintained a negative view towards junk bonds (high yield bonds) because of the high default risk during times of economic stress, and long-term bonds because of the expected return of inflation, which impacts all three.
Final Thoughts on Bonds
In our view U.S. bonds may consolidate in this range around 3.5% to 4% while inflation subsides somewhat. We expect bond yields to rise further when inflation does not return to the hoped for level of 2.0% which is where it started before the massive government spending programs of the last decade help create inflation. Bond prices will increase again when bond investors believe long term inflation will remain contained or a significant recession curtails demand. We will extend the maturity on the bond portfolios to capture yields and enjoy capital gains when interest rates do decline. We have been riding the short-term yield curves to higher income, adding to bonds while keeping maturity generally in the range of 1, 2, 3 years. By doing this we have increased the income and not exposed clients to one of the most devastating bond markets sell off in history.
Walmart, Target, Nike all reported reduced earnings recently. All three reported problems with inventories. Controlling the amount and type of inventory is one of the keys to successful retailing. Having merchandise consumers want to buy on hand is most important. These three retailers are some of the very best at controlling their inventories and running their businesses in order to be leaders of a very competitive industry. Supply chain disruptions primarily from China and doubling and tripling of orders by retailers distorted available inventory deliveries. This necessary mark down of prices to clear the inventory is resulting in large losses. We think the inventory supply issue is temporary and will be resolved when China moves away from their zero covid policies. China most recently announced the reopening of Macau, a city renowned for its casinos, indicating to us that the zero covid policy may be tempering. But in contradiction, last month China closed primary auto manufacturers city of Shanghai due to COVID, so supply chains will continue to be disrupted. The retailers have also had to adapt to a changing consumer. One who shops online and works from home, reducing mall traffic and the need for as many square feet of office and retail space.
We have been doing tax swaps for stocks and bonds to offset capital gains. We have doubled up on equity positions then waited 31 days to sell the higher priced share. As for bonds we have sold some small coupons bonds and replaced them with larger coupons. We have always encouraged in investors to realize tax losses and carry losses forward to reduce your current and future tax bill.
RMD’S AND GIFTS
We are beginning the last quarter of 2022. If you are required to take an RMD (required mandatory distribution) from your IRA or other qualified plan, you may want to think about QCD’s (qualified charitable distribution). Please note that your check must clear the bank before year end, not just be dated in 2022 for the deduction. So don’t wait until Christmas. Another note on gifting, as part of the 2017 Tax Cuts and Jobs Act, estate tax rules were adjusted again. The estate tax exemption was raised to $11.2 million, a doubling of the $5.6 million that previously existed. The tax cuts are set to expire in 2025 and regardless of which party is in office, taxes will increase to pay for the increase in government spending. The tax exclusion for people who pass away in 2022, is $12.06 million (up from $11.7 million for 2021). For a married couple, that comes to a combined exemption of $24.12 million. It is important to plan your gifting now before the exemptions change.