Update on Market Volatility: Back on the Rollercoaster
Following two years of sharp and consistent market gain, the S&P 500 Index has fallen to levels not seen in over a year. And while bonds have offered some “relative protection,” the broad bond market has performed worse so far in 2022 than in any complete year since 1842. For clients looking at their statements, it may be only little comfort to know that diversification beyond the S&P 500 Index (into small and value stocks), and beyond the broad bond market (into shorter-term bonds) has protected against what would have otherwise been steeper declines.
“Inflation is the Crabgrass in Your Savings”
While never easy to attribute market declines to a single factor, few would question whether inflation has played a major role in the recent decline. U.S. consumer prices were up 8.6% for the year ending March 2022, the largest annual increase since January 1982. Against this backdrop, the monetary policy response of the U.S. Federal Reserve, specifically that of its Federal Open Market Committee (FOMC), has become the center of attention for both stock and bond investors. Using a wide range of tools in its toolbox, the FOMC is attempting to tame inflation by raising interest rates and restricting the supply of money. As rates go higher, consumers and businesses have greater (smaller) incentives to save (borrow/spend).
At its May meeting, the FOMC voted to raise the federal funds target rate range by 0.50% to 0.75%-1.00% and signaled similar 0.50% increases would be on the table for the next couple of meetings. Notably, Chairman Powell ruled out the possibility for a larger 0.75% increase, which may have comforted investors fearful the committee would be overly aggressive in tightening policy. In addition, the committee also announced an end to quantitative easing, the program that began during the Global Financial Crisis in which the Fed used its own balance sheet to purchase bonds to further suppress rates.
With these recent moves, and the corresponding decline in both stock and bond prices, investors might be left pondering Robert Orben’s quote above. After all, isn’t the reason we invest beyond savings accounts to beat inflation?
How Much Does the Federal Reserve Influence the Bond Market?
Investors might predict that further interest rate hikes will lead bonds to underperform cash and that longer-term bonds will underperform shorter-term bonds. Thus, they might choose to shift their allocation from bonds to cash or favor shorter-term bonds.
As these narratives have gained media attention, it’s worth examining the empirical relation between the federal funds rate, global bond performance, and term premiums (the difference in returns between longer-term and shorter-term bonds). The federal funds rate is the overnight interest rate at which one depository institution (like a bank) lends to another institution some of its funds that are held at the Federal Reserve. The FOMC meets regularly to set the target for the federal funds rate. Bond prices and yields reflect the aggregate expectations of all market participants, including opinions on how and when the Fed will act in response to macroeconomic conditions.
Is Cash Really King?
Using FTSE World Government Bond Index data spanning over 30 years across multiple countries, researchers at Dimensional Fund Advisors examined the relation between the change in the federal funds rate each year and the returns on government bond indices in excess of cash over the following year. Exhibit 1 shows that average annual government bond excess returns relative to the U.S. dollar (USD), the euro (EUR), the yen (JPY), and the British pound (GBP) were positive and similar in magnitude regardless of changes in the federal funds rate in the past year across all four major currencies. Therefore, the analysis does not support the idea of allocating away from bonds to cash in response to changes in the federal funds rate.
While this research may seem counterintuitive, if not contradictory to the current environment, bond investors often fail to realize that higher interest rates are accretive to future returns. When it comes to bond returns, the initial interest rate (or yield), is the best predictor of return for the life of the bond. In other words, if we hold all else equal (no further rate hikes, no credit defaults), today’s price declines will deteriorate with the passage of time as bonds approach maturity, are redeemed at par value, and reinvested at higher rates of interest.
Exhibit 1: Relationship between FFR and excess returns between bonds and cash
Is Now the Time for Shorter-Term Bonds?
To answer that question, researchers at Dimensional Fund Advisors studied the relation between past federal funds rate changes and future term premiums. In this case, the researchers defined the term premium as the return difference between the 7–10 year and 1–3 year government bond indices for USD, EUR, JPY, and GBP. Again, as shown in Exhibit 2, we found no reliable relation between past changes in the federal funds rate and future term premiums. We also observe positive term premiums on average regardless of changes in the federal funds rate in the past year across all four major currencies. Therefore, while Truepoint has always employed a more conservative, shorter-term bond portfolio than the aggregate index, shortening portfolio duration in response to changes in the federal funds rate is unlikely to lead to better investment outcomes. Even if the timing and direction of federal funds rate changes could be predicted perfectly, we would still not know for certain how other interest rates would react. Research by Nobel-winning economist Eugene Fama found that any effects of the target federal funds rate on other rates dissipate quickly for longer maturities, and that there is no conclusive evidence on the role of the Fed versus market forces in the long-term path of interest rates. Despite its significant policy role, the Fed is one of many market participants in a larger ecosystem that impacts yield curves at large.
Exhibit 2: Relationship between FFR and term premiums
What Can History Tell Us About Stock Returns?
While inflation and the corresponding monetary policy response have understandably rattled the bond market, equity investors may worry that rising interest rates will further decrease equity valuations and therefore lead to relatively poor equity market performance. However, history offers good news: equity returns in the U.S. have been positive on average following hikes in the federal funds rate.
What about the months after rate hikes? This question may be of particular interest when the Fed is expected to increase the federal funds target rate multiple times. Exhibit 3 presents annualized U.S. equity market returns over the one-, three-, and five-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. In reassuring news for investors concerned with the current environment of increasing rates, the U.S. equity market has delivered strong longer-term performance on average regardless of activity at the Fed.
Exhibit 3: U.S. equity market returns (Fama/French Total U.S. Market Research Index) following consecutive fed funds rate hikes, January 1983–December 2021
With several FOMC meetings remaining in 2022, the Fed’s signals and actions will continue to be closely watched by the market. As the Fed often signals its agenda in advance, we believe market participants are already incorporating this information into market prices. While it’s natural to wonder what the Fed’s actions mean for equity performance, research indicates that U.S. equity markets offer positive returns on average following rate hikes. Thus, reducing equity allocations in anticipation of, or in reaction to, fed funds rate increases is unlikely to lead to better investment outcomes. Instead, investors who maintain a broadly diversified portfolio and who systematically rebalance their portfolio during periods of heightened volatility may be better positioned for long-term investment success.
Expect the Unexpected
Readers may note that we’ve stopped short in this commentary of predicting any near-term market reversals. As we’ve always said, while we don’t have a crystal ball, the good news is that we don’t think you need one to have a successful investment experience. Exhibit 4 illustrates that, on average, investors in the S&P 500 Index have historically experienced intra-year declines of 14.0%. Therefore, the volatility we are experiencing right now is very much in line with what we should expect!
We put up with these roller coaster rides because we know that the stock market has been more positive than it has been negative. In the past 42 years, 32 have been positive—and that’s excluding dividends!
Exhibit 4: S&P intra-year declines vs. calendar year returns
And the same is true for the bond market. As one may have expected, Exhibit 5 illustrates that the intra-year declines of bonds are smaller in magnitude and that the calendar year returns have been positive in 42 of the last 46 years.
Exhibit 5: Bloomberg U.S. Aggregate intra-year declines vs. calendar year returns
When we examine market volatility throughout our history, the data overwhelmingly suggests that investors are best off staying the course. And while we don’t know the timing of the next recovery or bull market rally, we are confident there will be one. That is one reason why our investment philosophy is grounded in a long-term strategy of disciplined, real-time portfolio rebalancing—so that our clients can capture the opportunities of a fluctuating market. This consistent approach deters us from giving in to the emotions of the moment, which often spur other investors to run for the hills.
We’re here to counsel you during stressful times and to help keep you on the path we have charted together. As always, please feel free to give us a call if you’d like to talk.