Investment Commentary: Q3 2023

By George T. Padula, CFA, CFP®

Co-Chief Investment Officer, Wealth Manager & Principal

October 13, 2023

What does your investment journey look like?
I was driving down Interstate-81 in August while taking my daughter to her masters program at Virginia Tech (dad brag), when I heard the Talking Heads song, “We’re on a road to nowhere” come on the radio. It’s a favorite from my 1980s college days. I couldn’t help but wonder, are investors feeling like they are on an unknown investment or economic road, going nowhere fast? Sometimes it feels that way with all the headlines, recent equity downturns, rising rates, and geopolitical uncertainties.

In the last 15 months, I have been in 19 states (20 if you count the emergency landing in Minneapolis) via 22 airplanes, 4 Amtrak trains, and driving thousands of miles for family (ME, vacations, conferences, client visits, and office meetings with colleagues).

While my view from the middle seat hasn’t always been pleasant, I can tell you that the economy is not standing still. It is rolling ahead down the road and flying through the air, sometimes at breakneck speed. Airports are packed, hotels are full, tourists and 18-wheelers are everywhere, and traffic is getting tougher every day. All of these boost the economy and are a welcome sight given where it looked like we were heading three years ago.

All is not always clear skies and smooth sailing, though. We know that an investment journey is going to have twists and turns, ups and downs, stops and starts, potholes, smooth pavement, turbulence and smooth skies. The goal, though, is to look forward using the information we have now to map our way forward.

Economic news:

Source: Ycharts

Inflation has continued to slow down with the year-over-year change in Consumer Price Index (CPI) currently at around 3.7% above the Fed’s longer-term 2.0% target, but well below the 8% inflation rate at this time last year.

Interest rates rose in September pressuring stocks and bonds. Headlines bounced between the narrow avoidance of a government shutdown and the impact that interest rates may have on government debt payments. New claims for unemployment benefits rose moderately, while layoffs declined in September, making for an overall strong jobs market. Additional data showed the ISM manufacturing index (PMI) slowly improving and consumer sentiment has been positive.

Market news:

Equities and bonds were down this quarter after an incredibly strong start to 2023. Despite a -3.3% decline in the third quarter, the S&P 500 is still up 13% year to date and has averaged 11.8% annually for the past ten years. International developed stocks are up 7.6% YTD, and nearly 27% for the past 12 months.

Fixed income returns long-term have been led by corporate bonds and municipal bonds, up 4.2% and 2.3% respectively per year for the past ten years. Even real estate, which many are questioning, has averaged 3.1% annually for the past decade, vs. 1.1% for the aggregate bond index and 2.3% for emerging market equities over the same period.

Let’s start mapping our investment journey even more with longer sets of data. How do stocks, bonds, and inflation compare to one another?

Source: DFA Returns Website. See full disclosures

Here is what we notice:
  • There is a preponderance of positive returns for long periods of time, whether
    for stocks or bonds.
  • Only three out of 19 5-year periods from 1932-2022 did the S&P 500 underperform 1-month treasuries for a 5-year period.
  • Stocks beat intermediate treasuries (5-year maturity)
    in 15 of 19 five-year periods.
  • Intermediate treasuries beat inflation in 13 of 19 five-year periods. Two of the times they didn’t were during WWII.
  • US equities were broadly helpful at combatting inflation in the 1970s when inflation was above 3%.

The point of the above is that while it is important to see what the economic and market data look like this quarter and this year, if that is your sole focus, you will never leave the driveway. You need to map out the longer-term strategy to get anywhere.

We have been getting a lot of questions on interest rates, inflation and cash so let’s cover each:

The current interest rate environment:

A rising rate environment is certainly challenging. At least with higher rates, investors are getting paid to wait through the volatility and are getting paid for their cash positions. For nearly 13 years, November 2009 – August 2022, the Fed Funds rate was UNDER 2.5%. What we are experiencing now is an environment that many investors have forgotten about.

Will rates go higher?

Short-term interest rates are high now but may not be going forward. A 12-month treasury is yielding 5.43% and a 24-month treasury is yielding 5.08%.[1] This implies that the annual interest rate between months 12-24 is 4.74%. In other words, the “market” is expecting lower rates going forward.

What about inflation?

As shown in the chart below from the St Louis Federal Reserve Bank, the 5-yr TIPS/Treasury breakeven (BE) stands at 2.17%. (TIPS = Treasury Inflation Protected Securities). The 5-yr BE is an implied measure of anticipated or implied average inflation over the next five years. In other words, the forecast is for moderating inflation ahead. The green line is 2% inflation – the Fed’s stated inflation target rate.

Source: Federal Reserve Bank of St. Louis, 5-Year Breakeven Inflation Rate [T5YIE], retrieved from FRED, Federal Reserve Bank of St. Louis, October 9, 2023.

How then do we think about a fixed income strategy?

Quality: We aim to keep credit quality high. By combining treasuries, high grade corporate bonds, high grade foreign bonds, even adding in higher yielding bonds, one can still have a weighted average credit quality that is investment grade.

Duration: Don’t reach for risk. Duration is the measure of risk per change in interest rates. The US Aggregate Bond Index as of September 30, 2023, has a duration of approximately 6.5 years. This implies a 1% increase in interest rates would cause the Aggregate Bond Index to decline in price by 6.5%. Keeping duration as a risk mitigation tool around 5% means that the portfolio will experience about 25% less interest rate risk than the index, ceteris paribus (all things being equal).

Diversification: Diversification helps smooth out turbulent markets. Treasuries, corporate bonds, US bonds, foreign bonds, taxable bonds, municipal bonds, short-term and longer-term bonds all have to be part of a fixed income strategy.

Income: It is not just what you earn, but what you keep. Don’t ignore tax equivalent yields that municipal bonds can deliver. A 3% tax free municipal bond yield is the same as a 4.2% taxable yield at a 28% tax rate or 4.5% if at a 34% tax rate.

Seek income from dividends, too: Dividends for the S&P500 from the end of 2007 through the end of 2022 averaged 6.5% annual growth, meaning dividend income more than doubled over the last 15 years. Dividends can serve as an anchor to windward in an uncertain economic environment.

Cash savings: Cash should be PART of a financial plan but should not BE the strategy. Look for opportunities to earn higher interest rates via high yield savings accounts, I Savings Bonds from the US treasury, or CDs.

Let’s bring this back around to the Talking Heads. Their song also included these lines: “We know where we’re goin’… and the future is certain, …give us time to work it out.” Somewhat positive, yet realistic, I’d say.

No matter your investment journey, know that there are always some bumps along the way. We cannot promise the future, which may seem uncertain at times. That is why having a solid plan – a financial GPS – to help guide the way is so important when you wonder if you are heading in the right direction. Having a plan, being diversified, focusing long term while being aware of short-term issues, and mapping out pathways are all part of the process. We aim to use our experience, knowledge, and research to help determine the right paths for clients. Thank you for allowing us to help you along your journey.

[1] U.S. Department of Treasury

Indexes are unmanaged, statistical composites, and their returns do not reflect payment of fees an investor would pay to purchase the securities they represent. Such costs would lower performance. It is not possible to invest directly in an index. The indexes include a different number of securities and have different risk characteristics. Past performance of the indexes and benchmark is no indication of future returns.

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Performance for periods greater than one year are annualized unless specified otherwise. Selection of indices and time periods presented are chosen by advisor. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

S&P 500 Index: Total returns in USD. Source: Standard and Poors Index Services Group for the period January 1990 – present. Source Ibbotson data courtesy of © Stocks, Bonds, Bills and Inflation YearbookTM, Ibbotson Associates, Chicago (annually updated works by Roger C. Ibbotson and Rex A. Sinquefield for the period January 1926 to December 1989.  Copyright 2023 Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

US Consumer Price Index: Source Bureau of Labor Statistics represented by Consumer Price Index for All Urban Consumers (CPI-U), not seasonably adjusted. The CPI is updated with a one-month lag.

One-Month US Treasury Bills: Total returns in USD. Source: Morningstar for the period January 1926 to present.

Five-Year US Treasury Notes: Total returns in USD. Source: Morningstar for the period January 1926 to present.

Dow Jones Global Select Real Estate Securities Index: Source: Dow Jones for the period January 1993 – Present.

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