How Should We Respond?

There are few single answers in finance and economics.  The reasons behind the market’s recent performance are no exception.  What follows are a few vignettes of combinations of factors I believe are contributors:

1. Modern securities markets are remarkably efficient pricing mechanisms. Millions of trades are placed every day by buyers and sellers who discount the future profitability of the stocks or bonds they are exchanging to today’s price. The implication is that markets serve in a forecasting capacity, or “leading indicator” of future economic performance.  These predictions are not always perfectly accurate, but they are the aggregation of millions of smaller predictions made by global investors and therefore represent a consensus opinion.  Short-term volatility is not always indicative of that consensus; however, longer-term trends often point to correlate to realized macroeconomic performance.

2. A corollary to point 1 above is that early signs of credit weakness appear to be surfacing with higher credit-risk borrowers. The hard reality is that most of Americans live from paycheck-to-paycheck, and often overuse credit cards out of habit or necessity.  To no surprise, higher credit card interest rates make already-inflated goods less affordable.  It is widely believed that consumers will reach an inflection point at which time credit-providers will cease access to said credit and buying patterns will change.  Auto loan defaults and bankruptcy filings are trending up, however, the strong labor market has likely muted some of the effects of inflation and higher rates.  In an economy comprised of 70% goods and services, “consumers” who can’t consume as much will reflect in lower corporate profits and lower stock prices.

3. The bond market continues to be pummeled by persistent inflation and expectations of “higher for longer” interest rates. Ironically, continued economic strength is exacerbating the situation as the market views this strength as simply delaying point #2 above.  I won’t pretend that you share my fascination with the nuances of credit markets, and will spare you a dissertation, however, it is a complex subject that can be summarized by a useful exercise of putting yourself in the shoes of both borrower and lender.  In the role of the lender, you are now realizing meaningful “riskless” rates of return in cash and cash-equivalent securities such as CDs, short-term treasuries, and certain high yield savings accounts. On the other hand, borrowers of all stripes, including the federal government to corporations and to homebuyers, have experienced ballooning credit costs engineered by the Federal Reserve to stave off inflation. The practical consequence of the rapid rate increase has been a depression in bond values (the market discounts bonds that are paying lower coupon rates such as those issued before the Fed’s run-up in rates).  There are two positive takeaways, however.

First, investors do not have to take as much risk in their portfolios.  Practically speaking, the same 2-year Treasury note we purchased eighteen months ago returned approximately 1.5% at best.  Today, that same note returns +/-5.25%.  These types of instruments have less sensitivity to interest rate movements as they are constantly maturing and being re-issued.  Additionally, it is a fact that these debt instruments are backed by the most credit-worth institute on the planet: you, the American taxpayer.

Secondly, the bond-market rout, recent market volatility, and Federal Reserve action are all nearing a two-year anniversary.  Statistically, that’s about the average duration of these cycles.  Please hear (read) me clearly that I am by no means predicting a market turn-around, as I wholly believe additional volatility is a real possibility. However, see point 1 above: markets typically turn-around before the full economic fallout is realized.

You’re probably asking yourself, “so what?”  Let me start by exhorting you to consider what has changed in your life?  If you have experienced a loss of employment, health event, or shifted your expectations of retirement, it is worth reviewing the level or risk in your portfolio and reassessing your financial plan.  If your health, retirement, near- and long-term financial goals are largely unchanged, we invite an opportunity to connect with you, but would also remind you that market movements are typically short-lived.  We, and you, should be guided by expected rates of return while appropriately pairing the level of risk to desired goal.

Finally, we manage portfolios in categories or risk based on expected rates of return as aforementioned.  While some portfolio managers will make aggressive changes frequently swinging between conservative and aggressive allocations, a deluge of empirical data suggests this is often a fool’s errand, and very few managers consistently “get it right.”  Your portfolio is paired to the level of risk you have conveyed to us and is appropriate for the goal of that portfolio.  We will not deviate from it without your consent but maintain that market volatility is rarely justification for making a significant change to allocations.  We recently completed portfolio reviews and are happy to share that in addition to several fund replacements, we tilted the fixed income components towards the shorter maturities as previously discussed.

As usual, we welcome an opportunity to review your financial plan and account performance.  We are deeply grateful for the confidence our clients have in the firm to provide your wealth management and planning services and acknowledge how disconcerting volatility can be.  We are here to remind you of your goals and the discipline you exhibited on the journey to achieving them.