Where do we go from here?
Since the onset of Covid 19 the US government earmarked $5 Trillion for financial relief, small-business loans, bailouts, PPE, state aid, and vaccine development. That is a remarkable 22% of expected 2022 US GDP virtually borrowed from a digital printing press at the Federal Reserve. This is on top of a US economy that was already projecting a $1 Trillion deficit and one with more federal spending on the way with the recently introduced American Jobs Plan.
So far, the result has been exceptional for nearly every asset class. Stocks are up 85% from Covid lows, it’s impossible to buy a house without paying above list price, Bitcoin has only gained momentum, and commodities are on fire. Of course, there are still a few areas of pain as nobody knows how many office workers will return or when business travel will resume, but by in large if you owned anything over the last 12 months you’ve done well.
The major exception to this has been the bond market. Vanguard’s total bond market fund returned 0% over the last 12 months and lost 3.5% so far this year. Longer term bonds performed much worse. The 30-year US Treasury yield increased from a low of 1.12% to close the first quarter at 2.40%. More than doubling in yield over the year! Bond yields and price have an inverse relationship. If you owned a long-term bond fund this year you lost 15% of your money. So much for safety in bonds.
There are two possible explanations for higher bond yields. On the one hand we are about to experience the strongest year of growth in over three decades. Expansionary periods are bad for low-risk bonds as investors seek higher returns elsewhere. On the other hand, significant government spending has bond investors worried that inflationary pressures are more than transitory. Inflation is bad for fixed rate bond holders because their purchasing power declines over time.
That doesn’t mean bonds can’t hold a place in a balanced portfolio. They still provide relative stability in volatile markets and modest cash flow. Since we own individual bonds with known maturity dates, as long as the company or municipality remains solvent we lock in a rate of return over the life of that bond. On top of that, we keep the average maturity of the bonds short. If interest rates increase over the next few years, we can reinvest the return of principal at higher yields. That’s great news for savers.
It’s not great news for bond mutual fund and ETF holders. Since the life of a bond fund is theoretically infinite there is no true maturity date. Although the underlying bonds mature over time, higher interest rates could subject the funds to significant price fluctuations. This can be further exacerbated by money flowing out of bond funds as they will have less proceeds to invest at higher interest rates. That means that any money paid out in coupons could be negated by price declines in the funds.
The flipside to higher yields is that our portfolios tend to benefit from modest inflation. We finally saw the rest of the market start to catch-up to the large cap tech companies. Investors rotated into our financial, energy, and industrial companies throughout the quarter as it became clear the economy was on the road to recovery and vaccines would be widely available sooner than expected. Demand for everything from materials, cars, houses, and semiconductors lifted earnings expectations as we emerge from our caves. To date we’ve been rewarded for not chasing the “work from home” companies to ever higher valuations.
So where does the market go from here? Will the rotation into more traditional value stocks continue? Have growth stocks sold off enough to where they are reasonably priced? Will interest rates march significantly higher as the economy reopens? Will inflation run rampant?
All great questions that we can’t pretend to know the answer to. We do know that there is seemingly little upside in bonds with a 10-year Treasury at 1.70% so we will remain defensive in our fixed income investments with short maturities and good credit quality. We also continue to see heavy pockets of speculation in SPACs, ESG, Crypto and other sectors that experienced strong momentum last year. At some point there will be interesting opportunities for investment but for now our clients are better served watching the spectacle. In the meantime, we’ll continue to build and hold solid portfolios with great companies at reasonable valuations that will benefit from the inevitable recovery.
Lastly, we want to thank everyone for staying the course last year. It was a challenging year for many, but we persevered, and we have this quarter’s results to show for it.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.