2022 has been a historic year for the market but not “the market” people normally think about when they hear the term. The term “the market” is typically used to tell how the U.S stock market has performed over a given period (a day, a week, a month, a year, etc.). However, the U.S bond (sometimes called the credit) market is the one currently setting records, and not in a positive way. Through the end of October, the Bloomberg Agg1 was down almost 15%. Since 1976, its largest annual decline has been 2.7%. The stock market has always been the headline grabber, but the bond market is around two times the size of the stock market and bonds play an important role in most portfolios.
While the pullback in the stock markets this year has not been as historic as the bond markets, the losses have been even greater. The S&P 5002 was down over 23% through the third quarter. We see stock markets down 20% about every seven years, so while not fun, it is not without precedent. The difference this time is that bonds have not provided the diversification they normally do when stocks sell off. What has been the cause of market turmoil this year?
- The Federal Reserve (the Fed) was wrong on inflation in 2021 – Federal Reserve officials spent 2021 telling everyone that the rise in inflation throughout the year was transitory (temporary) and would come down once the effects of COVID-19 had passed. Even though inflation ran 4.7% for 2021, the Fed never raised the Federal Funds rate3 above 0.00% – 0.25%. So….
- The Fed has aggressively raised rates in 2022 – The rate that started at 0.00% – 0.25% now stands at 3.00% – 3.25%. To combat an inflation rate that currently sits at 8.2%, the Fed has quickly raised rates. Why has the quick increase in rates caused so much pain in the bond and stock market?
- Bond funds are a collection of bonds that were issued in the past; therefore, most have a lower interest rate and thus lower interest payments. As interest rates rise, investors will pay less for bonds that pay less income and the value of the bond fund decreases. Bond funds frequently have bonds mature, and they replace these bonds with ones that pay higher interest. When rates rise slowly, the decrease in the value of the bonds is offset by higher income generated by the new bonds. That has not happened in 2022. Rates have shot up quickly and the increased income (yes, it is higher) has not been able to overcome the decreased value. The longer the term of the bond, the more it is hurt by rising rates. The total return of bond funds (income + capital appreciation) will recover due mostly to the increase in income, but it will take time. When rates decrease (and they will at some point), bond funds should see capital appreciation.
- Individual bonds are no different. They lose value as rates increase, but an investor will get the original value of the bond back if the bond does not default. Keep in mind that bond defaults are very low, at less than 1% for investment grade bonds.4
- The increase in rates have hurt stocks since investors can no longer count on TINA. This is an acronym that stands for There Is No Alternative. For the last few years, stock prices have been high by historical P/E5 standards. Cash and much of the fixed income market was providing zero to little return. Stocks, while expensive, were still an attractive investment because of TINA.
- Inflation is not just a U.S. problem – Countries around the world are dealing with inflation. Germany’s inflation rate sits at 7.90%, United Kingdom’s 8.65%, Mexico’s 8.70%, Brazil’s 8.73%, and Turkey’s is an astounding 83.45%. I just picked these out; there are plenty more examples. Like the United States, countries must raise rates to combat inflation, and we have already seen what rising rates can do to stock and bonds prices.
- Russia is still in Ukraine – Putin continues to fight a war to take land from Ukraine. This has direct effects, most notably for European countries, as it has increased the price of oil, natural gas, and food prices when prices on everything are already increasing. There are indirect effects, as well, because anytime countries are at war, it creates instability in the world as well as in markets.
- China – Continues to pursue its COVID-Zero policy. While much of the rest of the world has come to understand that COVID-Zero is unattainable, China shuts down entire cities when COVID cases rise to a certain level. With the second largest economy in the world, this continued disruption inevitably affects the global economy.
- Philadelphia Phillies – The Atlanta Braves let us down. Not only did losing to the Phillies cost them a chance to defend their World Series, but it might point to a bigger downturn in the economy. It is almost assuredly a coincidence, but World Series titles for the Phillies came in 1929, 1930, 1980 and 2008. 1929 and 1930 were the beginning years of the Great Depression, 2008 marked the Global Financial Crisis, and while the stock market returned over 30% in 1980, the United States was in a recession during the first half of the year.
Where do we go from here? Short term, it is hard to say with any confidence, beyond acknowledging volatility is likely to continue. We know stocks are cheaper than they were on January 1st of 2022. We can’t say they will not decline further in the short run. Bond funds will see higher income distributions due to higher interest rates; however, until the Fed quits increasing interest rates there could be further deterioration of capital. It is important to remember that when the Fed lowers rates in the future, it will help bond funds recover. We believe having a plan is paramount to long-term success when investing. Appropriate asset allocation protects you from having to sell stocks (or bonds) when they are way down. We have mentioned this in the past, but now is a good time to review your portfolio to see if there are any losses that can be harvested to help you offset gains this year or in future years.
As always, we are here to answer any questions you may have.
– Will Bowen, Relationship Manager
The views and opinions expressed are of Persium Advisors, LLC. This commentary is provided for educational purposes only and should not be construed as investment advice. Persium Advisors is an investment advisor firm located in Atlanta, GA.
1The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by traders and managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
2The Standard and Poor’s 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most followed equity indices.
3The federal funds rate is the interest rate that U.S. banks charge each other for uncollateralized, overnight loans. As these short-term loans are a foundational part of banking activity, small changes in the fed funds rate can create big impacts on financial and economic activity.
4Investment grade refers to the quality of a company’s credit. To be considered an investment grade issue, the company must be rated at ‘BBB’ or higher by Standard and Poor’s or Moody’s. Anything below this ‘BBB’ rating is considered non-investment grade.
5The price-to-earnings (P/E) ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
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