Bonds are Back
Through the end of the third quarter, the U.S. stock market is down -25.4%, international stocks are down -28.8%, and the aggregate bond index is down a historic -15.6%(1). The unusually high correlation of negative returns is primarily a result of the Federal Reserve’s aggressive rate hikes and their outsized effect on global financial markets. Never in history have the stock and bond markets simultaneously notched full year declines of this magnitude (2). 2022 has shown the Federal Reserve’s growing influence on financial markets, and how their policy decisions have consequences for stocks, bonds, and international economies.
Bonds remain the biggest market story of the year. Prior to 2022, the worst calendar year for bonds since 1976 was -3.0% in 1994 (1), but as mentioned bonds are down -15.6% this year. But beneath the aggregate index level, returns in the bond market have been uneven. Investors who hold bonds that mature in 1-3 years are down -5.0% so far in 2022. But investors who own bonds maturing in 20+ years are down a whopping -30% on their bonds (1). The good news is bonds are now the most attractive they have been in 15 years, and government bonds provide safety against the risk of recession.
Geopolitics in Q3 continued to be front page news, as Vladimir Putin’s invasion of Ukraine showed signs of faltering. After Russia annexed eastern regions of Ukraine, the Ukrainians launched a sweeping counterattack and recaptured much of their lost territory. In response Putin has mobilized hundreds of thousands of reserves to fight in the war, but many of the men are untrained and lack modern equipment to fight. Russia has continued to use energy as a bargaining chip against Europe, but we have yet to see an uptick in cyberattacks as was expected. If the war does escalate, we could see Russia put more cyber pressure on European energy, which would reverse recent declines we’ve seen in certain commodity prices. Ultimately Putin has limited options, and he knows that escalating the war with chemical or nuclear weapons will further isolate him from the few allies that remain. The harsh economic sanctions from the West have been effective at crippling Russia from rebuilding their military, and deterred countries such as China from providing financial and military support.
Navigating market volatility in any stage of life highlights the importance of maintaining an appropriate combination of stocks, bonds, and cash based on portfolio objectives and financial planning. Over any one-year time period, stocks, bonds, and even a 50/50 stock/bond portfolio have a wide range of potential returns. However, as the chart below indicates, over a rolling five-year period a 50/50 portfolio of stocks and bonds has never lost money, and the worst five-year return for stocks and bonds was down -3% and -2%, respectively. Our mission at JFG is to allocate our client’s portfolios across asset classes according to their time horizon and financial goals, mitigating short term risk with cash on the sidelines while remaining invested for multi-year objectives.
The title of our Q2 2022 commentary, “Don’t Fight the Fed,” was meant to warn against investing opposite to the Federal Reserve. Raising interest rates is the Fed’s blunt tool to fight inflation, and it is very hard for them to have a precise impact without causing further damage. However, after the Fed’s series of rate hikes, a significant amount of negativity is reflected in today’s market. In 2021, we were not bullish on future bond returns due to our belief that inflation would lead to higher interest rates. But since September 2021, the interest rate on a two-year U.S. Treasury bond has gone from 0.29% to 4.2% (1). As mentioned earlier, government bonds now look the most attractive in years for the defensive investor, and savers can finally rejoice for having a place to park their cash and earn interest. Investment grade bonds are also at their highest yields since 2009 (1), but they do have some credit risk as the U.S. looks increasingly likely to enter a Fed induced recession.
For the opportunistic investor, we are beginning to see value nibbling at certain areas in the stock market. Stocks were significantly overvalued relative to history in 2021, but after this year’s decline stocks look more reasonably valued. The uncomfortable reality is the highest investment returns are earned during periods of most uncertainty. As we have said in the past, we believe high quality companies will continue to outperform highly speculative and unprofitable companies over the long term. Many unprofitable companies that went public in the past two years are down 70, 80 or even 90%, and will likely never return to their highs. But for companies trading at reasonable valuations, with future growth potential, and experienced management teams, we are finding instances to put money to work.
In conclusion, we acknowledge this year has been incredibly difficult for investors. Diversification across investments is the ultimate risk management strategy, and unfortunately diversification this year has only softened the blow. Peter Lynch, who ran Fidelity Investments’ flagship Magellan Fund, once said the most important organ for investing is not your brain but your stomach. We will continue to manage client accounts to their investment objectives, and guide portfolios through these uncertain markets.
Thank you for your continued trust in Juno Financial Group.