Rates have been rising this year for several reasons – the Fed raised rates on the short end higher than expected, growth has been surprisingly accelerating the past few quarters – which we have detailed across our webinars and recent writings (The Market Comes to Terms with Higher for Longer; Should the Fed Have Seen This Coming?). Often forgotten in the muck of higher mortgage rates, higher car payments and other costs associated with higher interest rates, are the increased savings consumers have amassed and the increased income they are receiving on that cash balance.
Due to COVID lockdowns and excessive stimulus by the Federal Reserve and US Government, consumers saved more than their historical trend to the tune of over $2 Trillion. Those excess savings have slowly been drawn down since the spring of 2021 as the world returned to normal and inflation ate into people’s purchasing power. It is also normal after a down year like last year (-25% on the S&P 500 through September of 2022) for investors to shy away from increased stock allocations within their portfolios. However, this is counterintuitive – investors should buy low and sell high, but instead get greedy at tops and fearful during selloffs. Still today, people remain overweight cash and cash equivalents.
However, there is another, long-forgotten variable that is still preventing investors from adding money to beaten-down stocks. 5% interest rates! Short-term US Government treasuries can yield north of 5% going out as far as two years. The old acronym, TINA, which stood for There Is No Alternative (to stocks), is no longer true. The 2-year treasury yield over 5% is something investors haven’t seen consistently since 2001. The 2-yr Treasury yield topped out at 5% for about a year and a half in 2006, but that was short-lived as the Fed quickly found itself cutting rates to stimulate the economy in the 2008 financial crisis. This alternative is having wide ranging impacts on everything from VC & Start-up funding (now there is a real risk-free rate to compete with) to, you guessed it, investor behavior!
But as always, let’s look at this through a more practical lens. In a possible world of entrenched, higher (3%) inflation, do you think you will need more than 2% real growth (5% yield less 3% inflation) from your portfolio over the next 20-30 years? Fixed income certainly has a place in client portfolios, especially those relying on income distributions of more than 2-3% of your portfolio – we say 2-3% because a portfolio of dividend-paying stocks can yield that, and you would never need to touch principal to live. For those that don’t plan on touching their money for 10+ years, 5% interest rates alone should not sway you towards including more, and potentially any fixed income in your portfolio.
Let’s look at an example…let’s assume you have a 5% fixed interest rate in a 3% inflation world, for a 2% real rate of return. Your investment assets will double after about 35 years. You won’t have any volatility, but your net worth isn’t going to change all that much, especially if you need some of that income to live. In contrast, average annual returns for bull markets are around 20% and every fifth year we typically see a bear market of about -32%. If we assume we’re 1 year into a new bull market, an all-equity portfolio following the return pattern of 20% for four years and -32% for the fifth year of the cycle, less inflation of 3%, your purchasing power would quadruple around year 35.
The point of this exercise is not to say, “never invest in fixed income”, but instead to always keep your goals, time horizon and risk tolerance for your assets in mind. For anyone under 55 with 10+ years to work and no real need for the funds anytime soon, there can be a strong case made for forgoing 5% interest rates in favor of the long-term growth potential of stocks as part of a well-diversified portfolio For those that do need cash flows from their portfolio, evaluating how much and for how long via a financial plan can be a great tool to determine the best asset allocation for your funds.