he last few weeks have been difficult for investors. Persistent inflation has forced the Fed into a decidedly hawkish stance, aggressively raising rates by adding another three quarters of a point last week. Fed statements have reinforced they have no intention of backing down. Chairman Powell warned this could bring “some pain” to the economy.
This put investors in a challenging spot, trying to navigate between inflation on one side and the risk of a recession brought on by the Fed’s rate hikes on the other. Against that backdrop, both stocks and bonds reversed July and August’s rallies and have fallen back to June’s market lows. As of last week’s close, the S&P 500 was down roughly 20% and the 10-year Treasury surged to a multi-year high of 3.7%. Obviously the media went into hyperdrive with worst-case scenarios.
Our Perspective: Interest rates, market returns and recessions
During times like these it is tempting to listen to extreme voices and positions. We prefer to look at the numbers and market history. One reason this decline might feel worse than others is that in most declines, bonds provide stability to the portfolio. This time not only did bonds not help, but they also contributed significantly to portfolio declines. This is likely temporary.
Time for a little bond math. Studies show that returns from bonds are overwhelmingly determined by the current yield of the bond. In fact, over 90% of the total return comes from the current yield with the rest coming from the movement of interest rates to maturity. With bonds now yielding far more than just months ago, the future coupon from bonds looks brighter than it has in years.
Another reason this decline may feel worse than others is that this decline is different from the pandemic-induced sell-off of 2020. The 34% lightning-fast drop of the S&P 500 was far greater than the current decline. While people were still busy looking for masks and hand sanitizer, fueled by easy money policies, the markets mounted a quick recovery and raced to new highs. Even though the current decline is not particularly long as bear markets go, it seems long and grinding in comparison. But it will pass.
Now for recessions. There seems to be a lot of confusion as to what they are and what they mean. In listening to the financial media or your golf buddies, one might think that when a recession is declared, the skies darken, and the stock market drops significantly. The actual definition of a recession is a decline in industrial activity generally defined as a fall in GDP for two consecutive quarters. That’s it.
Again, market history can help. Since 1945, there have been 13 recessions, so they are relatively common occurrences with the last one being a mere two years ago. Of those 13 recessionary periods, six were positive for the S&P 500 and seven were negative, not nearly as ominous as one might expect.
We are not dismissive of any of this. The challenges could last for a while. We understand the effects of this on both your investments and you. Right up there with the mathematics of portfolio construction is our understanding that there are people attached to the money we oversee for clients. We are always mindful of that.
We are here to help. Communication is important during times like these. Please feel free to call if you would like to talk.
Sources: Federal Reserve, S&P Global, Standard & Poor’s, Barclays Indices, Wall Street Journal, Bloomberg. Vanguard