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Volume 11, Edition 28 | September 19 – September 23, 2022

A Cautionary Tale of Attractive Yields

Doug Walters, CFA
With bond yields rising, it is increasingly tempting to give in to their lure. But what opportunity are you giving up by locking in their attractive rates?

Contributed by Doug Walters, Max Berkovich, David Lemire, Eh Ka Paw

It was another ugly week for stockholders. The market weakness combined with rising yields on bonds has prompted many investors to consider increasing exposure to fixed income. After all, you can get a 4% yield on a three-year Treasury these days! When looking at recent performance, the case for a move like this feels compelling on the surface but is likely precisely the wrong tactic for long-term investors.

It has been a tough stretch for investors. US stocks are down over 23% year-to-date, and many categories of bond funds have had double-digit losses. It is easy to be lured into complacency in this environment from attractive fixed income yields. The three-year Treasury, a virtually risk-free investment, will earn investors over 4%. So why not throw in the towel and lock in that return for the next three years? Here’s why:

  • Bonds are not the only asset class that is now more attractive. The sell-off in equities has made them cheaper as well. If you rode the stock market down like a disciplined long-term investor, you will want to reap the full rewards of the recovery when it comes. Locking in 4% might sound attractive now but could be dwarfed by a stock rally. And…
  • You already benefit from those higher fixed income yields if you have bond funds. Bond fund values have fallen as rates have risen, but expiring securities in those funds are being replaced with higher-yielding bonds. That trend will continue.

The bottom line is that now is not a time to hide from equities. We are just starting to see some real value opening up in the stock market. Specific segments, like Value and Momentum, are beginning to look particularly attractive.

We do not have a crystal ball and do not claim to be able to predict the future. The current bout of weakness could continue beyond this year, or we could be close to the end. So we focus on what we know: stocks have become much cheaper this year. Is it time to back up the truck?… probably not. But should investors be seeking to replace stocks in their portfolios with the safety of US Treasuries?… absolutely not.

4.6%

Peak Fed Funds Rate?

The median peak Fed Funds Rate forecast increased to 4.6%, seemingly catching investors by surprise and providing another catalyst for the equity sell-off.

Headline of the Week

US stocks performed poorly this week, falling over 5% and turning negative on the quarter. Only one headline seemed to matter to investors: the Fed’s rate decision.

  • On Wednesday, the Fed raised interest rates again by 75 basis points (bps). That puts their current target rate at 3-3.25%.
  • Expectations were for 75bps, yet the markets reacted negatively when the rate decision came in as expected. Such is the nature of the current investing environment.
  • The Fed also stuck with its previous plan to reduce its balance sheet (quantitative tightening). They have been reducing their balance sheet by $47.5B per month, which increases to $95B this month and thereafter. While raising the Fed Funds rate increases short-term rates, the quantitative tightening is designed to increase longer-term rates.
  • The negative surprise for investors was perhaps the Fed’s median peak rate estimate of 4.6%. This forecast was higher than expected, and 12 of 19 policymakers forecast a peak rate higher than that.

The Week Ahead

Lots of talking is going on all week from Central Bankers, but the marquee report will be the Personal Consumption Expenditures Index (PCE) on Friday.

All Eyes on PCE

The Federal Reserve will take October off from hiking rates, but the gauging of its subsequent hike’s magnitude will officially kick off Friday with an inflation report.

  • The Personal Consumption Expenditures Index (PCE) was the Federal Reserve’s preferred inflation gauge for a long time, but Consumer Price Index (CPI) may have moved up that list.
  • Whether it is a preferred measure or not is insignificant at this point. What does matter is if we see any easing of inflation.
  • Unfortunately, consensus estimates are not very optimistic and are looking for a slight increase in inflation. With core-PCE (excludes food and energy) edging up to 4.8% for August from 4.6% in June.
  • The personal spending report will accompany PCE, and so far, spending has gone up every month this year. The trend should continue with some easing in gas prices in August.

Old News

U.S. Gross Domestic Product (GDP) for the 2nd quarter will have a final read.

  • The previous reports were based on mostly estimated numbers. This report should have mostly real data.
  • If the estimating mechanism works as it should, GDP will not budge from the last estimate.
  • The 0.6% contraction is expected to be reiterated.
  • The slight decline was better than the initial estimate of a 0.9% decline.
  • The consumer propped that number up. Can it do it again?

Talk, Talk, Talk

With all the major Central Banks out of the pre-meeting silence period, there will be lots of “he said, she said” noise to move markets.

  • Japan’s Kuroda, EU’s Lagarde, and Chairman Powell will be the headliners, but next week’s line-up is deep.

Party like it’s 5783

Monday is Rosh Hashanah, the Jewish New Year.

  • For those celebrating: May this New Year be sweet, healthy, and happy. L’shanah Tovah! Happy Rosh Hashanah!

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