One Tough Year

two houses in front of a mountain range

Written by Chris Draughon

I want to see you achieve your financial goals so I spend my time making the complicated things simple. As the Director of Financial Planning I help our clients identify their most important financial goals and develop paths to get them there on time with room to spare.

December 2, 2022

We’ve almost made it to the end of the year. And what a year it has been.

You may recall that in January, we were trying to set expectations that returns for client portfolios this year would likely be modest at best, considering each of the three previous years had positive returns. For the record, this year’s negative returns in both stocks and bonds are not what we had in mind for “modest.” We’ll have a recap of how the financial markets ended the year in January, but for now, it’s looking like the typical diversified portfolio (assuming markets are stable from here on) is going to finish the year down in the range of 13 to 15 percent. We hope we’re wrong and returns finish better.

We acknowledge that negative returns are frustrating. Our portfolios are invested just like yours. But it’s important to put this year into perspective. We can then start setting expectations for what might happen going forward.

The most under-appreciated part of this year’s experience

No one expected the Federal Reserve to raise interest rates as aggressively as they have. In January, the Fed Funds Rate – the rate the Federal Reserve charges banks to borrow money from them overnight – was 0%. The very accommodative policy was put in place in response to the shutdown of the economy in March 2020. It is very likely that this interest rate will be more than 4% at the end of the year. Some commentators have suggested the Fed was late to the party, but the truth is they’ve raised rates faster than they’ve done in 40 years.

Why have they been so aggressive with raising interest rates? To fight inflation which is at 40-year highs. We’ve talked about inflation during our quarterly webinars, so we won’t go off-topic here other than to say there are signs in the economy that inflation may indeed be trending down. Time will tell.

The first thing to be impacted by higher interest rates are the values of financial assets. For stocks, higher borrowing costs theoretically reduce profits which should reduce the value of the company. Hence stock prices decline. For bonds, as interest rates go up, the value of bonds already in the market paying a lower interest rate must decline to compete with newly issued bonds.

The speed and intensity at which the Fed has raised interest rates have meant that bond funds have seen their values decline by double digits. At its worst, the Bloomberg U.S. Aggregate Bond Index (the bond market) was down 16.8%. The market is on track to having its worst annual performance in more than 100 years. Stocks get all the attention, but bonds are the reason portfolio returns are suffering. A financial asset that is typically stable has been anything but this year.

The net effect of this year’s market performance is that diversified portfolios are back to where they were in 2019 prior to Covid.

The silver linings

Despite the frustrations that come from suffering a negative return and realizing we’ve lost three years of progress toward portfolio growth, we see two potential positives.

The first positive has to do with stock valuations. During the Covid Experience (what we are calling the period between 2020 and 2022), corporate America managed to increase profits to record levels. For perspective, the amount of earnings per share for the S&P 500 index is more than 20 percent higher today than they were in 2019, despite higher interest rates and inflation. Yet, the stock market is trading for the same price as in 2019. If profits remain at these levels, the value of stocks will eventually appreciate this reality.

The second positive may be more profound and impactful to long-term portfolio returns. Interest rates are now at levels not seen since before the 2008 Financial Crisis. You might recall that you used to be able to earn interest on savings accounts and CDs. And bond funds had average annual returns north of 4 percent. It’s been a long time since that was the case because the Fed kept interest rates very low following the Financial Crisis. Over the past 14 years, because interest rates have been so low, the bond portion of portfolios has not contributed much toward returns. Our long-term expected average return for a 60/40 portfolio has hovered around 6 percent for this reason.

Should interest rates stabilize at their current levels, it’s possible that bond funds could start to contribute more to portfolio returns like they did prior to 2008. If so, average annual portfolio returns could be higher over the next decade than they were over the last. We are beginning to think it’s time to raise our long-term return expectations.

It’s been a tough year for the financial markets, and we’re sure history will have much to say about this period. But for now, we continue to recommend patience and perspective. We firmly believe the worst of this experience is behind us, barring an unforeseen shock to the economy. Looking back, the thing we are most impressed with is how disciplined you’ve been in maintaining your investment and financial plans. If history is a guide, your discipline will be rewarded.