As we’ve been discussing in this blog since the Spring, the Federal Reserve’s hiking of interest rates will result in one of three outcomes: a recession (perhaps a deep one), stagflation (combination of high inflation and low or even negative growth), or a “soft landing” (the economy avoids a recession while inflation comes down meaningfully). Here we are many months later, and the jury is still out deliberating – we simply don’t know yet how this will play out. In the meantime, interest rates have soared to levels we haven’t seen in decades pummeling bond prices along with stocks. For investors who thought they had conservative portfolios, this has been an especially painful drawdown.
Is There Any Hope Out There?
Yes, there are certainly some reasons for optimism, but it’s quite possible that markets will deteriorate further before they get better. A recession in 2023 is not a foregone conclusion, but it’s certainly looking more likely. But consider that stocks might already be priced for a recession…this certainly looks true for small and mid-sized companies.[1] The money supply (M2) has continued to grow at a very slow pace for the last 6 months, which helps inflation – though it takes about 12 months to impact the inflation numbers. And there are many signs that inflation is cooling in key areas that were red hot: you don’t have to look any further than housing – with mortgage rates near 7%, home prices have run into a wall.
The Bear Has Also Gotten to Bonds
The terms “bear market” (price drop of 20% or more) and bonds don’t generally belong in the same sentence. But they do this year. By far, this is the worst year on record for bonds. Even conservative, investment-grade bond funds are down 20% and more this year.
But here is the good news with bonds: assuming the issuers of the bonds don’t default, then the bonds will mature at par value (i.e., the original cost of the bond). As the bonds approach maturity, they will regain their losses (up to par value).
Let’s use an example. Let’s assume you purchased a $1,000 U.S. Treasury bond yielding 2% last year, and its value has dropped to $950. Today, you’re not feeling very good about a 5% loss in value on “safe” investment. However, if you hold onto the bond until it matures in another year, then you will receive $1,000 from the U.S. government. You would therefore receive a $50 gain to maturity plus another $20 in interest. From here, that would be a return of 7.37%.
And if interest rates decrease between now and maturity – they typically do during recessions – then bonds could see substantial gains in value prior to maturity. Right now, markets are pricing inflation at 2.69% over the next five years.[2] If that comes to pass, then interest rates should drop alongside inflation in the next few years and boost the value of bonds.
Stick to Your Financial Plan
Investors are prone to making big mistakes at market bottoms and market tops. We’re all human, so it’s understandable that emotions would begin creeping into our thinking when markets move too far in one direction. The emotion is always rooted in fear: fear of loss and fear of missing out. If you’re feeling some fear right now, it’s understandable. But it’s crucially important that you do not act on the fear and exit your security positions.
And now, the boring but important stuff: There are three general asset categories: cash, bonds, and stocks. The key to financial planning is matching these categories of assets to the time in which you will need the money from your investments to fund the goals set in your financial plan. For goals coming due within 2 years, you should have enough cash on hand to cover those expenses (or anticipated cash from investments and other sources). For goals coming due within 3-7 years, we recommend bonds or other income-oriented investments. And for goals coming due 8 or more years from now, we recommend that you invest in stocks. Please remember that, on average, we recover from equity bear markets in a little over three years, so I hope this provides some comfort that you can wait out these downturns with some confidence.[3]
If you’ve done the proper financial planning, then this should help keep emotions out of investment decisions. Why would anyone liquidate a beautifully constructed portfolio of stocks when they won’t be needed for at least 8 years? Yes, bonds will be needed sooner, but we’ve already covered the built-in price appreciation you will get with bonds.
Don’t Forget the Opportunities Mr. Market is Presenting!
Roth Conversions
It’s a great time to consider a Roth conversion. For married people, tax rates are scheduled to remain lower through 2025, so considering a Roth conversion was a good idea anyway. But now it’s even better when you can move securities – at depressed prices – into a Roth IRA where, over time, they should rebound in price inside a tax-free vehicle. There are a lot of considerations prior to converting to a Roth IRA, so please obtain professional tax and financial planning advice prior to proceeding.
“Tax Loss Harvesting”
In taxable accounts, it’s an ideal time to sell securities to “harvest” losses to offset present and future gains. The idea is to sell an existing security that has a loss and reinvest in a similar security so that you remain invested. You cannot reinvest into the same security for 30 days or the IRS will disallow the loss.
Annuities
With higher interest rates, annuities are attractive again. They’re not appropriate for every situation, but they can be an excellent solution for certain situations. There is a lot to consider before purchasing an annuity. You give up liquidity, but you eliminate some important risks in your financial plan.
Certificates of Deposit (CDs)
We’re now seeing rates above 4% for brokered CDs that mature in one year. Considering that banks remain stingy on what they are paying bank depositors, a brokered CD might be a good option for your excess cash.
Conclusion
This has been one of the most difficult market environments I have ever seen. But there is no reason to panic. Stay patient, stay disciplined, and stay invested.
