During the last quarterly reporting cycle, I wrote to clients about the “shock and awe” that characterized the first half of 2023. The “shock” came from the failures of several financial institutions in March, which was accompanied by the “awe” that was the stunning rebound in equity markets, particularly in certain sectors exposed to the latest emerging trend of AI.
As I compile reports for clients now, one week into the final quarter of the year, it seems like markets and investors are yet again facing a “shock” stage.
This shock, much like the events in March, are once again caused by movements in interest rates. The interest rate curve has moved exponentially higher at all maturities in the last 3 months. The often cited 10 year yield on US Treasuries has moved up from 4.57% on September 30th to 4.74% at the time of this post. A~ 0.25% basis point move in five days is an unheard of movement – and that is following a 0.76% rise in Q3 2023. This rise in rates has driven down both stock prices (as its the rate used to discount future earnings) and bond prices (which are inversely correlated to yields)
However, unlike the events in March, these moves in interest rates aren’t being caused by the usual suspects of the Federal Reserve or inflation. If you’ll remember, the Fed paused at their last meeting and inflation has been coming down.
With the short-end steady and inflation falling, what is pushing up longer-term rates? It’s being driven by an increase in the term premium (the added return (ie: premium) investors demand to invest in securities with longer maturities (ie: terms)).
Why are investors demanding a higher return on longer-term US bonds in the last three months? This remains a topic of heavy debate, with the common answers being lower demand from other countries for US debt (as foreign rates are also rising and concerns over US credit ratings are circulating), higher supply with rising deficits and Fed’s quantitative tightening program, and higher expectations of future growth.
There are a lot of unanswered questions about the root cause of this rise in rates and about what happens next. This is just yet another “shock” that is impossible to fully unwind and interpret in a series of such events over the past three+ years. Let’s remember that no one – not government officials, market participants, or investors like you and me – have been thru a global pandemic/drastic fiscal stimulus/stunning collapse of supply chains/exponential inflation/exponential fed fund increase/sharp rise in rates experience before. This is unchartered territory so trying to predict the countless nuances of these moves is a fools errand and one we will leave to the business news channels.
What is worth looking in our view is how to remain confident in your long-term investment approach in today’s “shock” dominated world.
Here are four reminders I’m focused on that reinforce my enduring belief in investing.
1.) Higher rates are beneficial to investors/savers – Despite what all of today’s news stories would lead you to believe, higher interest rates can be a good thing for savers. If you have cash reserves, you are well aware of this as you are picking up 5% on these balances. If you have an allocation to fixed income (especially lower duration that we have recommended), any decline you’ve seen in principal during this rate move has likely been largely absorbed by yields between 4-8%. Higher rates allow investors to earn a meaningful real return on all areas of a balanced portfolio.
2.) Rising numerator = rising stock prices – Equity valuations are the present value of future cash flows, adjusted for a market multiple. Concerns in the past week are mainly over the denominator (ie: the rate used to discount future cash flows). The good news is that growth in the numerator (ie: earnings of the businesses) can overpower any increase in rates. In an economy where productivity and innovation are second nature, odds remain strongly in our favor that earnings will continue to grow and expand. We are confident that such earnings growth (rising numerators) will be observed in the coming weeks.
3.) US Economy has proven resilient time and time again
In his 2021 letter to shareholders, Warren Buffett wrote “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.” Whenever I find myself questioning the path forward, I come back to this quote, and Warren’s many other comments to this same end. The US is far from perfect and has its unique set of challenges. But a bet made against it over the past 200+ years would have been a losing one. It’s hard to view a bet made today any differently.
4.) Safe Return (Usually) Insufficient
There is no doubt that investing is not for the faint of heart. Times like this may make you wonder “why bother?” In fact, many are arguing that with the rise in rates, an investment in cash or US debt is a strong competitor to investing in other areas of the market, like equities. I agree – a “safe” return in a money market fund of 5% or 4.8% for a 10-year commitment to the US government would be more peaceful than a US equity market that can move 1% in an hour. Unfortunately, for the majority of investors, given the balance of their invested capital and expectations for future spending, a 5% return (that will likely retreat in time) is not a sufficient rate of growth. Volatility is the price we pay for higher long-term rates of return over time.
It’s been a long year yet again – and we still have one quarter left to go in 2023. We’re in the middle of a “shock” phase right now. I know it’s challenging. I know it’s uncertain. I know it’s not where we want to be – after all we’ve been thru since 2020. Try to remain optimistic. Keep your focus, keep your perspective, and keep your eye on the all but certain fact that “awe” is just around the corner.
Onward we go,
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