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Uphill Battle

Posted:February 18, 2023


Paul Hancock, CFP®    February 18, 2023

Last year proved to be a historically challenging year in financial markets. The S&P 500 was down 18.1%, its 7th worst loss in the past 100 years. While volatility in the stock market is nothing new, the bond market experienced its own case of a drawdown. 2022 saw the Bloomberg Aggregate Bond Market suffer its worse loss in history declining 13%. Put the two markets together in the bellwether 60/40 portfolio and investors experienced a drawdown of 16% in 2022. As seen in figure 1, 2022 was the 3rd worst year ever for the 60/40 portfolio.

Figure 1: 60/40 Portfolio Returns

Source: A Wealth of Common Sense

Central Banks finally got off the zero-bound and began raising interest rates in 2022. Currently, the market is experiencing 40-year highs in inflation and 13-year highs in short-term interest rates. Many leading economic indicators suggest a recession is imminent in the United States. The yield curve has seen a large inversion, which historically is a sign of a coming recession. The U.S. Treasury spread between the 2-year and 10-year Treasury bond is currently flashing a warning sign of a recession as seen in Figure 2. 

Figure 2: U.S. 2s10s Yield Curve and Recessions

Source: DoubleLine - Red shaded areas indicate recessionary periods.

Many market participants without a larger historical context have experienced an abnormal period of low-interest rates and very easy money since the global financial crisis. Central banks have been quick to pull the levers available to encourage economic growth and stable financial markets. Unfortunately, this cannot last forever. The Federal Reserve has an incredibly large uphill battle in the coming years. The question remains can the Fed tame the level of inflation by raising interest rates to a level that does not tank the economy and cause further instability in financial markets? 

The markets have now begun to transition from a “low return” world to a path closer to a “full return world” with short-term rates near 4-5%. Where this level shakes out remains to be seen. Keep in mind that the real interest rate remains negative with inflation hovering at 8%. Therein lies the challenge for the Fed; keeping interest rates high while hoping inflation eases just enough not to cause pain to the economy. Can real interest rates, (US Fed Funds rate minus the US CPI inflation) move to positive territory is a very important question for financial markets. 

Howard Marks of Oaktree believes that we are experiencing a “sea change” moment in markets. Marks suggests that the base interest rate/short-term rates should land around 2-4% in the next several years. This is a welcome reprieve from 0-2%. There will inevitably be very many bumps along the way, but getting financial markets off an easy monetary stance is very important. He wrote in a memo to clients in December the following:

“We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more so in the near term.  Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets.  Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21.  And importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.”



A Wealth of Common Sense -


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