Don’t fight the Fed is probably a phrase that you have heard many times over the years. What it generally means is when the Federal Reserve is lowering interest rates, it is normally a good time to be buying risk assets as they become worth more in lower interest rate environments. What we found out in 2022 is that this effect also works in reverse. If the Fed is raising rates, especially at the speed that they did as we realized in hindsight, it is a good time to reduce your positions in risk assets.
As it turned out, the pace of rate hikes was the most rapid in modern times. With yields starting so low (0%-0.25%) and the rate of change in tightening so fast, nearly every segment of the fixed income markets experienced declines, especially bonds with long durations. The 10-Year Treasury note experience its worst year as measured by total return in over 200 years with a loss for the year of 16.33%, high grade corporate bonds declined 15.8% and the 30-Year Treasury bond lost 33.3% for the year.
In past periods of sharply rising interest rates, bonds have usually delivered positive returns since the income from a bonds coupon offsets the decline in price. However, during 2022, with very little coupon income, returns were historically weak.
In addition to the returns in the bond market, the returns in the stock market left much to be desired as domestic stock indexes such as the S&P 500 dropped 18.1%, the Russell Mid-Cap index declined 17.3% and the Russell 2000 fell 20.4%. Non-U.S. stocks weren’t much better with emerging market equities dropping 20.1% and The MSCI EAFE (Developed Markets Index) declined 14.5% as the end of year decline in the U.S. dollar propped up European and other markets such as Japan.
A portfolio of high-quality bonds such as Treasuries and other government-backed bonds, and investment-grade corporate bonds-can yield in the vicinity of 4% to 5% without excessively high duration. Tax-adjusted yields in municipal bonds are also attractive for investors in high tax brackets. In addition to relatively attractive yields, higher coupons for newly issued bonds should dampen volatility.
It was just over a year ago that many articles were written about the death of the 60/40 portfolio. The 60/40 portfolio (60% stock and 40% bonds) dates back to the work of Harry Markowitz in 1952 and was quickly adopted by large pension funds as a way of balancing risk and return that allowed them to meet their pension obligations as bonds provided stability to the higher returning, but more volatile stock market.
This portfolio remains popular today as it has generally met its goals over the following 70-year period. There are many variations of this portfolio, but this is the way you will see it generally constructed and most often quoted.
Although this portfolio had one of its worst years in the 70 plus years dating back to 1950, it is only the third time in 73 years that the return was generated with both stocks and bonds having negative returns (1968 and 1974 were the other two). The good news is that the much higher yield on bonds is now better able to support either further increases in interest rates, although the feeling is that the Federal Reserve is likely to end their rate hiking cycle in the first quarter of 2023, or a decline in stocks. If the Fed were to need to cut interest rates to stimulate the economy, this rate decline would increase the value of your bond holdings and the positive return on the bond portfolio will once again provide protection against any decline in stocks.
As I have said in letters past, do not build your portfolio for the extraordinary or uncommon outcomes, but for the more frequent and common occurrences that will bring you greater prosperity.
Note: The yield on the 10-Year Treasury Note reached a low 0.55% in the late summer of 2020 and was under 1% for most of that year. If you were a buyer of these securities during that year, you left yourself little income protection and almost no chance of capital appreciation unless rates declined to 0% or below as they did in some European countries.
Please see the chart above with illustrations of returns on a 60/40 portfolio dating back to 1950. Including 2022 there have been fourteen instances where returns were negative of which half were losses of 4% or less and returns were flat or positive more than 80% of the time.