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On the Rise: Geopolitical Tensions, Inflation, and Interest Rates

By on April 1, 2022
Categories: MARKET NEWS

“Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.”

― Morgan Housel, The Psychology of Money

The first quarter of 2022 brought several economic, political, and geopolitical events into focus for investors.  Months after a generally tame 2021, and a welcome emergence from nearly two years of the COVID pandemic, a tidal wave of news raised new uncertainties for investors across the world:

  • The largest conventional military attack on a European nation since World War II, Russia’s invasion of Ukraine, shook the world as images of war flooded news networks and a united front of NATO countries levied heavy sanctions on Russia.
  • After the Russian invasion of Ukraine, the cost of a barrel of oil surpassed $100 and subsequently sent gas prices to record highs, above $6 per gallon in some parts of the country.
  • The Federal Open Market Committee (FOMC) increased the target range for its federal funds rate by 0.25%, the first increase since 2018. Reigning in high inflation appeared to become the top priority for the Federal Reserve (Fed).
  • In February, inflation hit its highest level in 40 years, with the Consumer Price Index (CPI) rising 7.9% over the previous year.
  • Bonds had the worst start to a year in decades. A broad proxy of the intermediate-term U.S. bond market, the Vanguard Total Bond Index Fund, closed the first quarter down 6%.[1]  The worst year on record for the fund was -2.66% in 1994.[2]

As investors closely monitored inflation, rising energy prices, and geopolitical developments, the broad market downturn impacted all asset classes during the quarter.  First quarter returns for equity and fixed income asset classes were lower across the board:

 

Index

 

Asset Class

 

First Quarter 2022

Barclays U.S. Govt./Credit—Int. Fixed Income -4.5%
S&P 500 Large U.S. Stock -4.6%
Russell 2500 Small/Mid U.S. Stock -5.8%
MSCI ACWI ex-USA IMI Foreign Stock -5.6%
S&P Global REIT Real Estate Securities -3.8%

A worrisome development during the quarter was Russia’s deployment of troops into Ukraine, despite nearly unanimous opposition.  In our modern world of nearly instantaneous information and capital flows, stock markets quickly rendered their verdict on Russia’s actions.  As Russia was hit with dramatic economic sanctions, the Russian stock market fell over 40% in the week leading up to the Ukraine invasion on February 24th, and subsequently suspended all market trading the day after the invasion.

Throughout history, wars and other geopolitical events have tested the resolve of investors. Investors’ initial reaction is often worry and panic, which sometimes leads to market corrections (down 10% from a recent market high) or even bear markets (down 20% from a recent market high).  History has demonstrated over the long run that markets tend to be resilient and digest news over reasonable time frames.  The initial fear often proves to be an overreaction, while opportunism and steadfastness have historically led to better outcomes.  Remember that the attractive historic returns on stocks include many challenging timeframes, including two world wars, recessions and depressions, high/low inflation, pandemics, terrorist attacks, and countless scandals. 

Vanguard evaluated the stock market’s reaction to numerous geopolitical events over the last 60 years.  While stock markets often react negatively to initial news, market selloffs are typically short-lived and returns over the following 12-month period are generally in line with long-term historical averages.

Source: Vanguard calculations as of 12/31/2021, using data from Refinitiv.

While decades of academic evidence and real-world experience indicate that market timing strategies are not effective over the long run, we are often asked what we are doing in reaction to sudden stock market volatility caused by geopolitical and other events.  The simple answer is that we are continuing to implement our disciplined investment process, which focuses on the factors that have most impact and benefit to clients over the long run.  We are rebalancing client portfolios to their target asset allocations, which in volatile stock markets generally means reducing bond exposure and adding to stock holdings at lower prices.  Buying stocks at cheaper prices has the potential to generate more attractive returns relative to what was available recently.  We are also taking advantage of the opportunity to harvest tax losses for our clients in their taxable accounts (revocable trusts, individual accounts, etc.).  Up to $3,000 of these losses can be applied against ordinary income on your tax return.  These tax losses can be used to offset realized capital gains on other assets, and any unused losses can be carried forward indefinitely to be used in future years.  Tax-loss harvesting can have a meaningful impact on long-term after-tax returns, and if missed, the opportunity goes away.

Rising Interest Rates and Bonds 

Another notable development in the first quarter was the Fed raising its key interest rate for the first time since 2018. The markets were widely anticipating the rate increase of 0.25% and the Fed delivered guidance that it could raise rates at each of its remaining meetings this year, for up to six additional increases in 2022. The prospect (and now the actuality) of rising interest rates has been a headwind for the bond market, as prices fell on current bond holdings, lowering total returns. The return of rising interest rates has led some investors to again question the value proposition of holding bonds in investment portfolios.

We strongly believe that bonds still play a crucial role in an investor’s overall portfolio – to provide liquidity, enhance current income, mitigate overall portfolio volatility, and hedge against inflation.

  • Liquidity for withdrawals and rebalancing of portfolios. An allocation to bonds can provide a source of liquidity for rebalancing portfolios during stock market downturns. If a 65% stocks/35% bonds portfolio experiences a decline in stock values and becomes a 60% stocks/40% bonds portfolio, a portion of the bonds can be liquidated and used to purchase stocks at lower prices, bringing the portfolio back in line with its target allocation.  For investors who are withdrawing money from their portfolio, an allocation to high-quality bonds can provide welcomed liquidity to fund spending needs for several years to come.
  • Overall return enhancement/interest payments. We do not invest in bonds with the goal of generating high income; however, bonds can provide modest returns to a portfolio through a constant stream of interest payments.  Rising interest rates can bring new, higher yielding bonds to the market.  Additionally, when bonds mature in a portfolio during a rising interest rate environment, the proceeds can be re-invested into higher-yielding bonds, adding additional return to portfolios.
  • Mitigating portfolio volatility. Even in a rising interest rate environment, bonds serve a key purpose — to buffer the more volatile stock portion of an investment portfolio.  A “bad” year in bonds is generally a decline of one to three percentage points.  A “bad” year in stocks is a decline of 30% to 40%, as we experienced during the financial crisis of 2008-2009 (it is important to note that during the financial crisis years, intermediate-term bonds were up 5.1%[3] in 2008 and 5.2%[4] in 2009, providing a much-needed buffer to declining stock prices).  Similar examples were seen during the stock market selloff in 1990, the tech bubble of 2000-2002, and more recently in the COVID downturn of February-March of 2020.
  • Inflation protection. It may be tempting to sell bond holdings and simply hold cash, but those funds would immediately begin losing purchasing power due to inflation, especially in the current, high inflationary environment.  Historically, bonds have provided a return premium over inflation, whereas cash has proved to be a deflationary asset class in the long run.

In managing client portfolios, we purposely keep bond maturities short-to-intermediate term to limit the negative impact of a quick rise in interest rates and to take advantage of higher yielding bonds when current bond holdings mature.  Generally, longer maturity bonds are more negatively affected by rising rates as investors are locked into low rates for longer periods of time.  We also have a strong preference for bonds with very little credit risk; as bondholders, we want to get paid back on time and in full.  Despite the constant stream of investment offerings enticing investors to “reach for yield,” we advise against replacing bonds with high yielding investments (preferred stock, Master Limited Partnerships, high dividend paying stocks, etc.), which often carry much higher risks, hidden behind enticing yields.

We do not know exactly how high interest rates are headed or how quickly those moves may happen.  It is even possible that the Fed could reverse or slow its current course altogether. For example, at their meeting in August 2001, the Fed indicated it would start to raise interest rates “relatively soon” after a long sequence of rate decreases.  Shortly after that meeting came the terrorist attacks of Sept. 11th, and the Fed cut interest rates by 0.5% at each of its next three meetings, keeping rates lower for the next several years.  Although taming high inflation seems to be the focal point of the Fed’s plan to raise interest rates, unforeseen market conditions could very well derail their current trajectory.

As we enter the second quarter, many economic issues remain unresolved, and the long-term implications of the global tensions with Russia, inflation, and rising interest rates are uncertain.  It is helpful to remember that the global stock and bond markets have been here before—and there are numerous reasons to believe the economy is in much better shape than some of the gloomy headlines may tell you:

  • The global economy has largely reopened after nearly two years of COVID lockdowns and restrictions. Business formations in 2021 reached a record high and jobs are plentiful.  People are beginning to travel, shop more, and return to their pre-pandemic lifestyles.
  • Many consumers are sitting on record amounts of cash, as discretionary spending over the last two years decreased, home values soared, and the stock market rebounded dramatically from the COVID lows of 2020. Pent up demand for goods and services may boost the economy for years to come.
  • A key inflation measure, the five-year “break-even inflation rate” in U.S. bonds, which is a technical measure of the bond market’s five-year inflation forecast, is currently just above 3.5%, or roughly half the current rate of inflation. In other words, the bond market may be predicting inflation will drop significantly from current levels.

For investors with appropriate time horizons and the emotional ability to tolerate the unavoidable ups and downs, we believe diversified investment portfolios of stocks and bonds will continue to generate attractive long-term returns.

Finally, the Securities and Exchange Commission (SEC) requires all registered investment advisors under its supervision, including Dowling & Yahnke, to provide clients with an annual summary of specific and significant changes that have occurred within the past year.  As such, we will provide our ADV Part 2A, Item 2:  Material Changes in an upcoming communication.  A complete copy of our most recent ADV is available upon request or may be obtained by visiting our website at www.dywealth.com.

We are deeply grateful for the trust our clients have placed in our firm.  We encourage you to call or e-mail anytime you would like to discuss your portfolio or other financial matters.

Sincerely,

DOWLING & YAHNKE WEALTH ADVISORS

 

[1] YCharts, Inc.; data for Vanguard Total Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX). Total return from January 1, 2022 to March 31, 2022
[2] YCharts, Inc.; data for Vanguard Total Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX). Total return from January 1, 1994 to December 31, 1994.
[3] YCharts, Inc.; data for Barclays U.S. Government/Credit Bond Index – Intermediate-Term. Total return from January 1, 2008 to December 31, 2008.
[4] YCharts, Inc.; data for Barclays U.S. Government/Credit Bond Index – Intermediate-Term. Total return from January 1, 2009 to December 31, 2009.

 

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