Investing in a high-rate environment

Nan Wang

Since the great financial crisis of 2008, our generation has grown accustomed to interest rates hovering around zero percent most of the time. This year, however, the US central bank has raised its Fed Funds Target Rate by the fastest pace since the Volker period, aiming to combat the highest inflation in decades.

In the span of less than a year, the benchmark interest rate has risen from 0%-0.25% to the 3.75%-4% range with another 50 basis points expected at the December Federal Open Market Committee (FOMC) meeting.

As inflation has started to show signs of peaking, investors are now debating whether the Fed will turn dovish next year. In fact, the Fed Fund futures market has priced in a rate cut in the last quarter of next year. The FOMC dot plot, which is a survey of policymakers’ prediction of future rates, indicates rates will move lower in 2024.

The US job market has so far shown resilience despite major corporations’ lower earnings guidance. The November unemployment rate held at 3.7%, close to its pre-pandemic low. Although inflation has eased in the past few months, the Fed’s preferred gauge of inflation, the US Personal Consumption Expenditure Index (PCE) is still at 5%, above the long-term target of 2%.

As Fed chair Jerome Powell has repeatedly emphasised, taming inflation is the committee’s first priority now. Policymakers are likely to slow the pace of rate hikes at its upcoming meeting, and might pause in the first half of next year, but rates are most likely to remain high throughout next year.

For investors, the question comes down to which investments to make in this new high-rate environment, after a particularly challenging year for those who already may hold lower-yielding securities.

The largest assets classes, from stocks to fixed income to real estate, have all declined in value year-to-date. In fact, the traditional 60/40 stocks-to-bonds portfolio has so far had the worst performance in 100 years. Through 30 Nov., the Bloomberg US Aggregate Total Return Bond Index posted a negative return of 12.6%, while the S&P index has declined 14.4% despite the latest rally.

Bonds

Looking forward to 2023, the selloff this year could be setting up for opportunities. According to Refinitiv Lipper, global bond funds had a cumulative outflow of US$175.5 billion in the first nine months of this year, the first net outflow in this period since 2002. Fixed income has become attractive as bond yields reset at higher levels, and the Fed is likely to become less hawkish in the new year.

Recently, interest payments on short-term Treasuries broke up through 4%. To put this into context, we could hardly get to this level with junk bonds at the beginning of this year.

As bond prices and yields are negatively correlated, higher yields have driven bond prices into deep discounts. Pension funds, insurance companies or individuals looking for a stable cashflow would find bond income appealing now. The S&P 500 estimated dividend yield is only 1.65%, while the average yield on BBB rated (the lowest investment grade rating) corporate bonds is above 5%. For risk-averse investors looking to park money into risk-free assets, money market funds are now offering yields above 3%.

Preferred stock

For those with bigger risk appetites, preferred securities are worth looking into. These hybrid securities have features of both common stocks and bonds.  They are typically junior to other bonds in the corporate debt structure, but have priority over equities in terms of dividend payments and claims to companies’ assets. The S&P US Preferred Stock Index is off 15% through 30 Nov., underperforming both the equity and the bond market. The selloff has pushed many preferred yields above 6%, as prices drop to near or below par value.

As the Fed approaches the end of its monetary-tightening cycle, next year could represent a good entry point for preferred stock. Financials, particularly banks, are the largest issuer of preferred securities. Banks have been holding up well despite the weakening economy. In the latest quarterly earnings reports, two thirds of financial companies beat their earnings forecasts.

US central bank data shows loan growth continues at a healthy rate of 1.9% quarter-over-quarter, or 12% year-over-year, and credit quality indicators remain stable.  Deposit beta is lagging; that means the sensitivity of deposit pricing to changes in the Fed Fund rate is lower than loans. For the upcoming year, all these factors should continue to support banks’ profit margins.

Equities

The US Treasury yield curve has become increasingly inverted. The two-year yield is 1.2% higher than the 10-year yield, which historically has been a leading indicator for recession. Equity market performance this year has definitely been positioned for a late cycle.

Defensive and inflation-resistant sectors, such as energy, health care, utilities and consumers staples, have outperformed, while more cyclical sectors such as consumer discretionary and technology shares have underperformed. Furthermore, the lower beta dividend strategy had led gains year-to-date.

In the new year, macroeconomic conditions will continue to challenge company profitability. While markets are hoping for a soft landing, many companies have adjusted downward their earnings outlook. However, keep in mind that the market often reacts ahead of the economy.

Stock sell-offs tend to happen prior to the worst part of an economic decline, but then rebound during the recession in anticipation of the impending recovery. That said, equity markets will likely remain volatile in the new year. High quality companies with strong returns, low earnings variability and low financial leverage should hold up better.

Optimising the opportunity

Investing in a high-rate environment has been difficult this year, as higher interest rates have hurt both bond and stock valuations. Nonetheless, marked down prices provide opportunities for select securities. Bonds and equities often provide diversification as money tends to flow into fixed income when risk-averse sentiment rises.

Although correlation has turned positive between the two asset classes this year, a diversified portfolio should still provide value over the long term. From 1980 through July 2022, the 60/40 portfolio delivered positive annual returns 83% of the time.

Each investor has his or her unique circumstances. Investment portfolios should be tailored to meet each individual’s specific risk tolerance, investment horizon, liquidity needs and other special restrictions.

When making investment decisions, keep in mind that in general, the longer the investor remain invested, the higher the chance of earning strong positive investment returns. Based on the performance of the S&P 500 index from January 1970 to September 2022, an investor who was invested for one year had an 18% chance of losing money.

Over five years, the odds of losing fall to 9.6%, and those who remain invested for 15 years or more did not lose money by investing in a broad basket of equities.

Nan Wang, CFA, is a portfolio manager at LOM Asset Management Ltd in Bermuda. Contact the Cayman office of LOM at (345) 233-0100 for further information.

 

Please contact LOM at +1 345 233-0100 or visit www.lom.com for further information.

 

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.