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The FOMC’s dot plot, which is perhaps the most boring but the most terrifying chart in economics and investing right now, is the summary of where members of the Federal Open Market Committee (FOMC) expect the federal funds rate to be over the next three years. It’s an estimate, not a mandate. Still, the most recent release of the dot plot shows a significantly higher range than it did in the last several meetings. The high water mark for interest rates, according to those dots, is projected at around 4.6%, which is considered to be the Fed’s terminal rate, or the end rate.
That’s significantly higher than where we are today, higher than where it was projected to be a few months ago, and it could move even higher if inflation remains high—especially core inflation, which excludes food and energy prices but does include shelter and electricity costs. As of last Friday morning, fed fund futures, which are derivatives based on the federal funds rate, were trading as high as 4.7%. Translation: interest rates are heading higher—much higher than we thought just a couple of months ago—how high is unknown, and that lack of visibility is like kryptonite for investors.
London’s calling and the news isn’t good. While the U.K. is still mourning the passing of Queen Elizabeth, new fiscal policies from the government of Liz Truss, who recently became the country’s latest prime minister, have investors running for the exits. Last week, Truss’s cabinet announced a series of tax cuts and heavy government borrowing to kickstart the country’s economy. With the U.K. economy likely already in a recession and inflation raging across the kingdom, heavy government spending and tax cuts for corporations may not necessarily be the prescription for a recovery, but that’s the tack Truss and her Chancellor of the Exchequer, Kwasi Kwarteng, are taking.
Last Friday, following these announcements, the British pound fell severely against the dollar, its seventh-steepest decline over the past 50 years, and the British government bond yield soared as investors dumped their holdings. Yields on government bonds hit their highest level since October 2007, and 10-year yields reached their highest level since 2010. The FTSE 100, the U.K.’s benchmark equity index, fell to its lowest level since March.
Just to put some things into perspective—as of April, the U.K.’s public sector debt was more than £2.3 trillion, or 95.7% of GDP. That’s approaching the highest level of public sector debt since 1962. The majority of U.K. debt used to be held by the U.K.’s private sector, especially insurance and pension funds. But in recent years, the Bank of England (BoE) has been buying gilts and taking hold of up to 25% of that public sector debt. Sounds kind of familiar, but a debt crisis in the U.K. would have a massive spillover effect across the world’s financial system—we’re going to keep an eye on that.
It’s also worth noting that next week is the final week of the third quarter, with Friday being the final trading day of September, which is historically one of the worst months of the year for stocks—and this year fit the bill. Through 182 trading days so far this year, 2022 has seen the fifth-worst start to any year in history for U.S. equities, according to compound advisors. The fifth worst—it’s hard to believe, but numbers don’t lie.
Last week, Investopedia and Morningstar teamed up for a day of investor education strategy and analysis. We called it Investor Connection, bringing together experts from Morningstar, Investopedia, and some of the smartest people we know in financial planning, portfolio construction, and wealth management. We held this event at our offices in New York City and streamed it online for more than a thousand investors who, like us, are trying to reset their strategies after a challenging first ten months of the year—to say the least. We’re going to bring you some excerpts of a panel I moderated on resetting our portfolios, given the new realities of higher interest rates, terrible returns in both the stock and bond market, and more uncertainty on the tracks ahead.
I was joined by Christine Benz, the Director of Personal Finance at Morningstar, who was also one of our first guests ever on The Express; John Rekenthaler, the VP of Research for Morningstar, and Anastasia Amoroso, Chief Investment Strategist at iCapital—also an Express regular. Here’s part of that conversation, and we’ll link to the entire conversation and all the other panels we hosted at Investor Connection with Morningstar and Investopedia, last week.
Caleb: "I'm going to start with you, Christine, because—and I think everybody would agree here—we haven't seen a market quite like this—I don't know if we've ever seen it—where you have this simultaneous decline in both the equity market and the bond market. The bond market is supposed to cushion you at times like this, but that's not what's happening now. Is there any precedent for this and any way to make sense of it, just from an individual investor's perspective?"
Christine: “It seems that the closest time period, historically, is sort-of the 70s, where we had rising rates, high inflation that did crimp stock and bond prices simultaneously. But certainly in my lifetime, and in many investors’ lifetimes, this is the first time we’ve seen that. Because historically, in the past few bear markets, at least, bonds had had a really nice cushioning effect for equity losses. So I do think the fixed income portion of investors’ portfolios is what really is worrying them and bugging them right now, because it is the asset that they had been looking to to provide a cushioning effect and it’s just not delivering, obviously.”
Caleb: “Anastasia, we’ve been living in this TINA world for a long time until recently, and now there is an alternative. In fact, there’s a few other alternatives, but for a while stocks were the only game in town—U.S. growth stocks were the only game in town. A lot of that’s changed. You watch a lot of these metrics closely. What are you noticing, beyond the fact that there’s now a place to get some yield, but you also watch the movement of money very closely?”
Anastasia: “Yeah, there’s a lot of different alternatives we’ll talk about in just a minute. But to pick up on Christine’s point, I mean, this is sort of the year we’ve been all scared of having, and we finally had it, right? I mean, think about the last several years—when we were look at bond yields and everybody was saying they’re way too low. When they rise, they’re going to rise, bond prices are going to collapse, and equities are going to reprice down in unison with them. So here it is. We had this year, and maybe this is sort of the clearing event that needed to happen.”
“But as a result of this repricing, Caleb, you’re right–there’s so many more alternatives to get yield in your portfolio. I mean, coming into the year, if you were sitting on cash—that was paying you zero, that was paying you nothing. If you were investing in high yield, the spreads had compressed so much and the rates were so low. The yield on high-yield debt was four-and-a-half, maybe 5%.”
“Well, you fast forward to today—and I don’t know about you, but I’m excited about looking at CDs right now. I’m excited about one-month, three-month certificates of deposit (CDs). Like we have not seen rates like this since 2005, 2006. So you can look at cash, you can look at short term-liquid cash alternatives, and you can get some yield. You could look at annuities, you could look at U.S. Treasurys—yielding you close to 4% for one, two, three-year paper. That’s really exciting.”
“And then you go out on the credit risk spectrum, and I realize you’re taking some credit risk, but high yield has repriced to 8.5% yield-to-worst. So, by the way, when yields are above 8%, the old adage says you’re supposed to buy that because once yields fall and spreads compress, that ends up being pretty good returns for high yield investors. So bottom line is—there’s a silver lining—and a major one is that after this major repricing in bond yields, there’s something to do in bonds again.”
Caleb: "Yeah. John, is it time for some boring investments? Is it time to be thinking about other things that we haven't really put into the investment mix. A lot of us, especially folks that are not in retirement yet, thinking about those other products. You talked about CDs—I get excited about CDs. We just need to get out a little bit more, I think—you and me. But you're getting a lot of offers in the mail these days. Is it time for some more boring, lower investments?"
John: “The thing that one tends to encounter, when you have downturns like this—people are thinking about, “hey, maybe it’s time to make a change in my portfolio.” They tend to look at what’s been working well recently. For example, I had quite a few people writing to me in April, May, and June, talking about commodities and commodity funds, asking me “should I have more commodities in my portfolio?” At least in that case, there was certainly an element of bolting the barn door after after the animals went out. Because I looked it up, and the commodity index is down 15% since the middle of June, which would be rather unpleasant, if somebody had gone in there in the middle of June for protection against rising inflation, and maybe even sold assets that had already lost money for them—and then bought something that dropped another 15%. Of course, if they stayed in stocks, they’d be down probably since then too, a little bit—but not by 15, at least not in most stocks.”
“So, the best thing to do in these circumstances is to look at what you already have in your portfolio, and maybe move toward some of the things that have been beaten up the most, like high-yield bonds, for example. Or at least if you’re going outside of your portfolio, you don’t buy high-yield bonds that you don’t have—something that’s already taken some bumps and legs, rather than chasing the most recent success. That’s the danger when you ask that question, “Should people be doing something new?” Yeah, but be careful of chasing that.”
Caleb: "And chasing the herd has not been a great strategy lately because the herd shifts very quickly these days. And I think everything is."
John: "It's not a huge herd, but there's been a small movement, at least—positively and toward commodities, for example."
Caleb: “Right. The velocity of everything just seems to be increasing over time. The speed at which we go in and out of recessions, or at least the last recession, the speed at which sentiment shifts. All of these things change, but some basic rules still apply. And Christine, I love your pyramid for thinking about how to invest and how to allocate your portfolio—we’re going to share that in the notes to this conversation. But you have some very basic things—talking about, you know, investment, what’s safe, talking about being tax efficient, your own behavior, trying not to get in the way of yourself, as we say. Talk to us through some of the things that just remain constant, no matter what type of market environment we’re in.”
Christine: "Sure. And just to describe the pyramid that Caleb referenced, it was the idea of the food pyramid—people who were in school during the 70s probably remember that it had us all eating a whole bunch of carbs. That was the base of the pyramid, that we should spend most of our diet on carbs—turned out that was all wrong. But the basic idea with this investing pyramid is if you have a fixed amount of time and resources, you'd want to allocate to the important stuff, versus things that do not deliver a good return on your time and your capital. So at the bottom would be having a goal, having a well-articulated goal, having a sense of what that investment goal will require in terms of funds."
“Managing your own behavior is certainly huge, and we have reams of data on how investors do oftentimes undermine their own investment success, by chasing—as John was talking about—chasing what has recently outperformed. Looking at asset allocation, making some basic decisions based on your life stage, your proximity to needing your money, about how to apportion your investments from conservative to more aggressive. So those would be some of the key things that should be part of investors’ dashboards today.”
Caleb: "Yeah. So no matter what, you've got to keep those in mind. Anastasia—I was kind-of astounded recently when I when I heard that ETF flows have actually been constant and actually been rising this year. I'm like, well, where's all of that going? Clearly not into the equity market, not into the growth part of the market. A lot of that has gone into fixed income—a lot of that has gone into short-term investments. But when you look at money flows more broadly, in the environment that we've been in, especially over the last couple of months. What are some of the things that stick out to you?"
Anastasia: "Yeah, so it's interesting that you bring up the ETF point, and I was actually puzzled to see that the ETF flows have been positive this year. But I think you're right to point out that it depends on what sectors of the market they've been positive in too. Which, by the way, mutual fund flows have not been positive this year. But investors, by and large, have still been buying the dip in equities. I think things that they have been buying have been the dividend-paying stocks. If you look at an ETF like DVY, for example, it is down only 3% for the year. So clearly, it's held up well in this inflationary environment and is guarding some of the flows."
“To pick up on something that both of you said before, I think investors really need to realize that we have had a big regime shift just in the last six months. All of us who have been investing since 2009 have been accustomed to this zero interest-rate policy. And what you did, as an investor, is you bought the dip in growth stocks. I mean, that was really the playbook for the last ten-plus years. And I think investors—myself included, by the way—are having a hard time with thinking that, no, you don’t just blindly buy the dip in all things growth, because that’s going to perform quite well.”
“So that’s why, I think, the repositioning that still needs to happen is…we might want to broaden out what is it that we buy the dip in, and maybe not every growth stock deserves to be bought in this environment. So I think that’s when we finally reach some sort of point of a washout, a capitulation—when investors finally realize that the environment that we’re in is not one where stocks without yield can perform well, but rather stocks that have either a solid cash flow yield, or a solid business model, and are priced accordingly—those are likely to do well. So I think if we were to dissect through the flows, that’s what I’d want to see first.”
Caleb: "Great point. And John, you've written about this before. Is there a threat, or is there a concern about over-diversification when you're thinking about ways to rebuild right now? Are there ways to maybe spread yourself too thin when you're trying to rebuild and reset your portfolio now?"
John: “Well, you know, I’ve seen many cases of people who send me their portfolios, and they’ve got 27 different mutual funds—that’s a lot of securities, right? Twenty-seven funds, and some of those are even index funds, and it’s kind-of like combining different target date funds. I don’t think there’s necessarily a harm in that, in the sense that when you do this, you’re just ending up with an index squared—and an index squared isn’t a bad thing, just as an index not squared is not a bad thing.”
"But it gets confusing to understand exactly how you're positioned, as well as just tracking all that stuff. I think most people actually would benefit from paring their portfolios rather than adding to them. But there's always the temptation—and look, we're up here talking about this, what to do now. You know things change—let's go add something. Well, maybe the proper thing to do now is actually to cut back on some things and simplify your life a little bit."
Anastasia: "I think that's such an important point."
John: "Well, good. I'm glad I made an important point!"
Anastasia: "You make a lot of great points."
John: "That's one in 45 minutes!"
Anastasia: "But personally speaking, as I was looking at my portfolio heading into the year, you know, I loaded up on things that I really liked, which is all things digital transformation and health care innovation and sustainability. And then, you know, what worked in an environment of zero interest rate policy is likely not going to work going forward. So you want to take some risk, but you want those risks to be well-calculated and you really want to know what you own. So, case in point, personally, I actually did pare back all these various individual stock exposures that I had, and I think that's probably what a lot of investors have done."
"And that's why there's not this sense of panic in the market right now, because people have de-risked their portfolios and, you know, you're going to own top semiconductor companies because you have a lot of faith in them; you're going to own your top biotech and health care companies. You're going to own some of the winners of the sustainability revolution. But you really, really want to know the companies, or ETFs, or mutual funds you own because, in the event of another market downdraft, you don't want to be guessing what those companies are going to do. You don't want to be guessing your value proposition for owning them."
Caleb: "Right. That expression—know what you own—so important, always important, but especially important right now. And it's those companies with cash flow, those companies with reliable cash flow quarter-after-quarter that are not at the whim of the economy, that might do a little bit better at a time like this. Christine, you know investor behavior very, very well. What are the worst mistakes investors can make at a time like this?"
Christine: "Well, John referenced the big one, which is chasing what has performed well in the very recent past. The good news is, when we look at fund flow data, we are seeing a pretty placid pattern on the part of investors. Investors are leaving stock funds a little bit around the margins, but for the most part, when we look at what investors are doing, they're staying pretty inert, which turns out to be a good thing from the standpoint of their portfolios. We have seen some action out of bond funds, but I think the fact that more flows are being driven by target date funds, more investors are just turning their decision making over to an automatic plan that does that rebalancing for them. I think financial advisors are driving more of the flows."
"We've been seeing sort-of a counterintuitive pattern for a few years now, where from 2019 through 2021, for example, we saw really strong flows into international equity. And of course, international equity didn't outperform U.S. equity during that period, but I think that rebalancing was going on behind the scenes—and, to my view, that very much rebounds to investors' benefit if they're outsourcing some of this decision making."
John: “If I can briefly just jump on to that point—I actually looked at this a little while back—flows into index funds. And you know, for a while, there was just one index fund—it was the Vanguard 500 fund, and that was that was the only index fund for many years. And then, you know, we got more of the manual-expanded and the growth fund, the value index fund, the small-cap fund, the mid-cap fund, and now we’ve got almost as many index funds as there are stocks on the market. That’s really not an exaggeration.”
“And in the early days, when these index funds expanded—and you look at the flows into them, they were very much chasing the performance tail. So in the late 90s, a lot of money flowed into Vanguard Growth Index Fund as growth stocks were the new era, and growth stocks—it was kind of like where we were recently, but about 20 years back, with the Internet stocks going way up and the value stocks just treading water, not making money. And then that reversed for three years, from 2000 to 2002.”
"Investors did not do well by that, because they bought into the growth fund at the top, and they didn't own the value fund. You see a lot less of that now. The index funds—even the little subsectors of the index funds, which could be tempting, or lead one to to buy this particular corner or that of the index— the flows are more stable, and in my view, more responsible. And I think it's related to what Christine said. There are a lot more people using index funds and models, and financial advisors using them—strategically, rather than as a tactical—rather than just as a whim kind-of-investment."
Caleb: “There is this kind of battle—it’s ongoing, active versus passive. Is now a time for good stock pickers or is now a good time to just let it ride on the good index funds? And we know a lot of investors, especially a lot of 401k investors—they’re passively invested, right? They’re just buying the same mutual funds or ETFs every month that they set their accounts up with. Is that, in your opinion—and I’d love to hear this from Morningstar and even from you, Anastasia—is that laying a safety net or a sort-of imaginary support line underneath the stock market itself? Just because there’s so much passive money that goes to the same places every month, no matter what happens.”
Christine: “Could be a contributing factor, I would think. And I have been thrilled to see the trend toward very low-cost index funds, because John and I, we’ve been doing this for more than 30 years. Every time we run studies about what factors contribute to good fund performance, it comes back to costs. It’s like Jack Bogle said…
Caleb: "Somewhere, Jack Bogle's smiling right now."
Christine: …the costs matter hypothesis. So it may be putting some artificial footing under stocks, at least a little bit. But overall, I think it's an incredibly healthy trend."
John: "I wish it would put a stronger footing on the stock market. You know, it's always tough to know what to do with flows—this year, the flows in funds have not been dramatic at all, and yet the stock market is down a lot. So somewhere, somebody is selling and somebody has been getting out and stock prices have shown that, but it's hard to see that in the flow numbers. But, yes, I think clearly, all things being equal, it's better to have this kind of passive—relatively passive, steady group, like the 401k monies that are coming in and supporting the marketplace. But there's a limit to what they can accomplish when interest rates rise, as they do now, and stocks are being repriced. Anastasia?"
Anastasia: "So to dissect that a little bit, who's been buying? Who's been selling? Actually, somebody asked me a question earlier today. If you were told in the beginning of the year that rates were not going to rise by three 25 basis point (bp) rate hikes—which is what we were all expecting coming into the year—but we were going to finish the year at four-and-a-half percent. You would probably think the market was going to be down 30%, right? Instead, the market is down 18% and that's kind of a good outcome."
“And I think part of the good news is that you have had this bid to equities from individual investors, or institutional investors, that are still deploying capital. And again, we see that in some of the ETF flows. I was surprised that equity ETF flows have actually still been positive for the year. U.S. equity ETF flows have been positive. So I think you have had this regional investor participation, you know, the trade participation.”
“But to dissect other parts of the market, you also have the corporate buyer, that’s one of the largest buyers in the market—and by the way, the reason why we’re having this very choppy September is because the corporate buyer is not in the market right now. They’re in the blackout window, so they’re not able to buy back their shares. But if you look at corporate buyback authorizations, they’re at record levels and they’ve been executing them as the equity markets pulled back. So I think, between the individual investors stepping into ETFs, between the corporate buyers stepping in to do share buybacks, that’s probably why, as bad of a year we’re having—it’s not worse.”
It’s terminology time. Time for us to get smart with the investing and finance term we need to know this week, and this week’s term comes to us from Katrina, who hit us up on Instagram. Katrina suggests sinking fund this week, and we love that term, given all the turmoil in the bond market, but also because I’d actually never heard of it. I love learning new terms, so thanks, Katrina. According to my favorite website, a sinking fund is a fund containing money set aside or saved to pay off a debt or a bond. A company that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship of a large outlay of revenue. A sinking fund is established so the company can contribute to the fund in the years leading up to the bond’s maturity.
The prospectus for a bond that contains a sinking fund will identify the dates that the issuer has the option to redeem the bond early, using the sinking fund. While the sinking fund helps companies ensure they have enough funds set aside to pay off their debts, thereby lowering their default risk, in some cases companies may also use the funds to repurchase preferred shares or outstanding bonds. I have a sinking feeling that companies are going to be adding a sinking fund to new issues in the near future as investors’ fears mount. Great suggestion, Katrina. A pair of Investopedia stylish socks are headed your way in the mail, and these have our brand-new design, and they look smart, just like you.
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