Not Out of the Woods Yet

PUBLISHED JULY, 2023

Not so very long ago, the captains of the wealth-management industry were calling for all aboard to batten down the hatches for rough seas ahead.

A year later? Well, they’re not suggesting it’s time to gather for daiquiris on the sun deck at 5, but they are breathing far easier—as are a good many investors. At the midpoint of 2023, it seems, most of the scowls over investment returns adorn the faces of those who tried to time the markets ahead of a recession that still hasn’t arrived.

If they did, they missed out on some serious but welcome developments:

• On the equities front, stocks have yielded six-month returns in the range of 14-17 percent.

• Yields on bonds are up 2 percentage points.

• Even cash, a dangerous position to maintain when inflation topped an annual rate of 9 percent last year, looks less threatening. 

• To top it off, a significant amount of investor cash is still sitting on the sidelines earning in the neighborhood of 5 percent. It is poised, wealth advisers say, to move into more lucrative uses at the first strong, sustained signals that the Fed may have indeed orchestrated a soft landing for the economy.

“If you had told me that the Fed was going to raise the front end of the curve 350 basis points and long rates would drop by 100 basis points, I would not have guessed that the S&P would be up 17 percent and NASDAQ up 30 percent” as of mid-July, said Dan Kieffer, director of asset allocation for UMB Bank. “Despite the aggressive rate increases, the Citi surprise index is in a very positive trend; financial conditions are trending positive and above zero.”

As far back as a year ago, Kieffer said, “The market was pricing in a recession in the back half of ’23 … today, it looks like that is being canceled. That’s not our base case, but that’s the stock market’s signal.”

Given where investors were at mid-point 2022, it’s hard to imagine how we got here from there. The nation was still waiting for the delayed impact of the Fed’s first 75-basis-point moves after that June; energy prices threatened to spike from July’s high of over $90 a barrel on the expectation of a tough winter in Europe and disruption from Russians’ Ukrainian escapades, stocks were off 20 percent for the year, bonds were down 10 percent, and even cash was getting less than 2 percent.

In short, says Mariner Wealth Advisors’ Justin Richter, “there was nowhere to hide” for investors. Now, he says, it’s not unreasonable to ask whether the Fed has indeed found a comparatively painless way out of the inflation cycle. But he cautions that sentiment may be growing too optimistic in the near term.

Indeed, says Scott Boswell, president of Commerce Trust’s west division, “uncertainty remains. Having rebounded from 2022’s lackluster performance, the capital markets are in positive territory for the year. … The Federal Reserve’s rate-hiking strategy to break inflation appears to be working, but inflation remains well above the Fed’s 2 percent target range. The robust labor market has buoyed the U.S. economy, which is showing signs of slowing.”

Still, Boswell says, the lingering possibility of recession casts a formidable shadow over the investment landscape. 

The Inflation Impact

Investors long aggrieved by near-zero interest rates on the safest instruments have reached a point where they can actually see positive returns, even after accounting for inflation. The latest consumer price index for June showed the first year-over-year inflation rate of less than 5 percent since February 2022—and even some banks have special offers now that exceed that level.

But does a difference of a few points really move the needle on investor behavior?

“Interest rates absolutely matter for asset allocation decisions—higher interest rates create competition for investor capital,” said Richter. “Particularly for retirees or near-retirees to allocate more heavily to cash/fixed income with yields north of 5 percent.”

The question for investors, then, is how much risk someone is willing to take to earn modestly more, he said. “Having a higher-rate environment for longer causes greater disparities between asset classes and within equity sectors. Investors need to be more aware of the interest-rate sensitivity of their investments as the cost of capital remains high.

For short-term savers, said Kieffer, the higher rates are a welcome relief from 15 years of near-zero returns. 

“Overnight rates (money markets, etc.) have moved above the inflation rate, enabling investors to get a real rate of return without taking on much, if any, risk,” he said. Typical investors can get CDs, and Treasury notes well above 4 percent for the first time in years, which he said was “a tremendous help to retirees living on the income stream from their savings.”

On a higher plane, insurance companies, pension plans, and other institutional investors have benefited with dramatically improved funding ratios as the rates on 10-year Treasuries closed in on 4 percent, Kieffer said. 

The potential downside?

“For those exposed to other, longer-term parts of the market, such as equities or especially sectors reliant on leverage, such as Real Estate or other levered markets, rising rates can be a problem,” Kieffer said. “Rising interest rates generally mean that far-off cash flows are worth less today (the ‘present value’ of the cash flows has dropped).

This hasn’t impacted equities yet, he said, but it could if rates move much higher. And on top of that, higher financing costs put serious pressure on the valuations of any leveraged investments.

The Bond Situation

As a result of Treasury rates’ upward moves, yields in other parts of the bond market have compressed, in relative terms, tightening the spreads between them. Thus, Kieffer said, “Investors don’t get paid very well today for taking credit risk.”

Interest rates weren’t going to sit on zero forever, but surging inflation, the Fed’s aggressive response, and tightening credit conditions played havoc with the bond market in 2022, Boswell said, creating a rare environment. 

“Bonds historically have acted as a counterbalance to equities, providing investors some protection when stocks underperform. This didn’t happen last year,” he said. “Although bond prices decreased, creating a negative return, ultimately, savers will experience the benefit of interest rates not being zero. 

That, too, will change if inflation rates continue their slow crawl down.

“The notion of transitory inflation got turned into a laugh line, but it’s finally proving to be right,” Kieffer said. “Inflation appears to be heading lower. The two-year treasury is telling you that the average Fed funds rate over the next two years will be around 4 percent—it’s now at 5.25 percent” as of early July, he said, “implying that overnight rates will be headed lower as a result of lower inflation.

With the average two-year real rate of return over the past 10 years an ugly minus -1.25 percent, the fact that it’s just above zero today represents “a much better value than we’ve seen in a long time. If inflation continues to head lower—as we think it will—today’s rates on safe intermediate-term bonds should prove quite attractive over the life of the investment.”

Inflation expectations, Richter said, matter far more than current inflation readings: For one, they determine if, over a given time horizon, the yield on a safe investment outpaces inflation expectations for the same period. Low-risk investors still come out ahead if five-year forward inflation expectations are around 2.3 percent while five-year treasuries are yielding close to 4.3 percent.

The recent inverted yield curve, he cautioned, could lead investors to be overallocated to short-duration fixed income. So it’s important to understand reinvestment risk if and when rates decline, he said.

Irrespective of your savings platform, “there is always risk with investing,” Boswell noted. “However, money market funds are considered less volatile than stocks and bonds. They can quickly be turned into cash or can help fund a new investment opportunity. And in our current higher interest rate environment, they are more lucrative now than they have been, with some money market rates approaching 5 percent. 

Outside Our Borders

Global events have a way of throwing monkey wrenches into the best investment strategies divined from domestic market movements and conditions, and investors will again have to factor overseas developments into the strategies.

The past year, said Richter, had produced events that led to a tighter banking environment, which in turn yielded more opportunities in private credit.”

With economic activity slowing somewhat, investors are a but uneasy, Boswell said.

“We believe investors need to remain resilient during periods of uncertainty,” he said. “History shows that disciplined investors who work toward long-term goals can often withstand periods of market unrest and be in a position to take advantage of investment opportunities that present themselves.” 

For those paying attention, this year has highlighted the case for international diversification, Kieffer said, noting that the Europe and Far East Index had outperformed the S&P 500 by 200 basis points. In addition, “emerging markets (ex-China) has kept pace with the lofty returns from our own Standard and Poors Index,” he said. 

Summing It Up

So what can investors expect for the remainder of 2023 and into 2024? Keep an eye on corporate earnings for guidance.

“With a questionable economic outlook over the next 12 months, equity prices could come under pressure if earnings decline,” Boswell said. “If the economy does slow, that would be good news for bond investors, as interest rates would decline, providing positive returns.”

“From us,” said Kieffer, “investors can expect caution. We don’t believe that we’re out of the woods yet regarding several uncertainties in the economy and markets. We don’t believe that we can experience unprecedented fed funds hikes, draining liquidity, and Russia participating in an active shooting war and have no consequences for risk-based assets.

“Over such a short time period, such as 18 months, we would maintain a neutral asset allocation and be prepared to take advantage of buying opportunities if the markets become turbulent,” he said.

Richter said he expects the Fed and its forecasters to remain “data dependent” as economic data is released. 

“At some point will we see a more significant, delayed impact of rates going from zero to somewhere in the mid-high 5s?” he asked. “We’re likely to see soft landing materialize, but risks remain, and volatility will return periodically.”

Thus, it’s important to not just anticipate but expect speedbumps along the way, rates to stay elevated through mid-2024, and a greater focus returns to valuations with the S&P 500 trading at 19x forward earnings, he said.

One final cautionary thread, Richter said, binds anyone with exposure to an office real-estate market showing signs of deterioration, a concern he said is shared by both “investor and bank.”