View from the Observation Deck  

Today’s post compares the average annual real rate of return (total return minus Inflation) on the 30-day Treasury bill (T-bill) over two distinct time periods: 1926–2007, and 2008–2022. 

One of these things is not like the other

From 1926 to 2007 the 30-day T-bill provided investors with a positive real rate of return of 0.68%, on average. Notably, the tables turned from 2008 to 2022, with the average annual real rate of return on the 30-day T-bill falling to -1.91%. A differential of this magnitude begs the question: what changed? 

Losing money safely

Following the financial crisis, the Federal Reserve (“Fed”) shifted to an “abundant reserve” monetary policy and held rates at zero, according to Brian Wesbury, Chief Economist at First Trust Portfolios L.P. (Click Here to see Brian’s Monday Morning Outlook covering this topic). This shift, combined with a protracted low interest rate environment led to a dramatic decline in the yields on 30-day T-bills, which were no longer able to keep pace with inflation. In fact, an investment in a 30-day T-bill would have produced a negative real return over the past 15 years (see table). 

Takeaway: In the 15 years since the financial crisis, investors have suffered a negative real rate of return in the 30-day T-bill. These returns stand in stark contrast to the 80+ years before the financial crisis when T-bills provided much-needed ballast against the erosion of inflation. The market has changed. Investors should weigh the impact negative real rates of return may have on their portfolios and consider adjusting accordingly, in our opinion.

U.S. Treasury Bills are represented by the Ibbotson Associates (IA) Stocks, Bonds, Bills, and Inflation (SBBI) series, “IA SBBI US 30 Day TBILL TR USD”.

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The S&P 500 Index returned 2.48% last week. After declining 5.76% in December of 2022, equities have shown resilience in January with the index climbing 6.11% YTD in 2023, posting only one negative week out of the four thus far in 2023. The Federal Reserve’s dual mandate of maximum sustainable employment and price stability has put them in an aggressive stance to combat the high inflation the economy has experienced over the past several months. This in turn has caused increased concerns over the equity markets with fears the Fed might slow the economy too fast or too much through their rate hikes and push the economy into recession. However, the U.S. economy has shown its own resiliency as 4th quarter 2022 GDP numbers released last week were higher than expected and U.S. initial jobless claims were reported at 186K last week, lower than the consensus estimate of 205K and previous week’s claims of 190K. Declining inflation readings since June and other recent economic indicators have also increased hopes that the FOMC may begin to slow their rate hikes and achieve a soft landing, which has given a recent boost to equities. Consumer discretionary was the best performing sector in the S&P 500 Index last week, followed by information technology and communication services. Consumer discretionary stock Tesla Inc. was the best performing stock in the index last week, returning 33.34% to finish the week at $177.90. The company reported earnings last week and the stock jumped on better than expected results. After hitting a closing high of $409.97 in late 2021, the stock declined 65% in 2022 and on the first day of trading in 2023 the stock hit a closing low of $108.10, a level not seen since August 2020. Intel Corp opened down on Friday after releasing their bleak earnings announcement which revealed a surprise loss and missed revenue expectations by a significant margin. Earnings announcements expected this week include Apple Inc., Alphabet Inc., Amazon.com Inc., Exxon Mobil Corp, Meta Platforms Inc., McDonald’s Corp, Caterpillar Inc., and many more. 

U.S. Treasury bond yields were mixed across the yield curve last week as investors digested economic data during the Federal Reserve’s blackout period, which limits Federal Reserve officials speaking engagements leading up to the rate decision meeting on February 2nd. In response, analysts and pundits weighed in on the size of the Federal Reserve’s next interest rate hike. According to the CME FedWatch Tool, by the end of last week the probability of 25 basis point increase reached 99.2%. Treasury yields rose on Thursday as domestic GDP data came in better than expected. Real GDP for the fourth quarter increased at a 2.9% annual rate, which was higher than expected 2.6% increase. Though the headline data looks favorable, strong inventories and personal consumption were the largest contributors, which will inevitably slow with the rest of the economy in 2023. The week ended with the Federal Reserve’s preferred measurement of inflation, the PCE Deflator, pulling back to 5.0% in December from 5.5% in November, indicating inflation is slowing. Major economic reports (related consensus forecasts, prior data) for the upcoming week include Monday: January Dallas Fed Manufacturing Cost Index (-15.0, -18.8); Tuesday: 4Q Employment Cost Index (1.1%, 1.2%), November FHFA House Price Index MoM (-0.5%, 0.0%), January MNI Chicago PMI (45.0, 45.1) and January Conference Board Consumer Confidence (109.0, 108.3); Wednesday: January 27 MBA Mortgage Applications (N/A, 7.0%), January ADP Employment Change (160k, 235k), January ISM Manufacturing Index (48.0, 48.4), January ISM Prices Paid Index (41.8, 39.4) and February 1 FOMC Rate Decision (upper Bound) (4.75%, 4.50%); Thursday: January 28 Initial Jobless Claims (200k, 186k), January 21 Continuing Claims ( 1678k, 1675k), December Factory Orders (2.3%, -1.8%) and December Final Durable Goods Orders (N/A, 5.6%); Friday: January Change in Nonfarm Payrolls (185k, 223k), January Unemployment Rate ( 3.6%, 3.5%) and January ISM Services Index (50.5, 49.2).

View from the Observation Deck  
Today’s blog post builds on our last one (Click Here for "Uncharted Waters"), where we discussed how the increase in the unprecedentedly low federal funds rate impacted the equity and fixed income markets in 2022. Tuesday’s post got us thinking: how did the markets perform in the wake of the rate hike cycles we highlighted? The table above shows the federal funds target rate at the start of the calendar year, as well as the total returns of a 60/40 blend over the one-year and three-year time frames that followed.

Significant reductions to the federal funds target rate (upper bound) combined with favorable U.S. fiscal policy enabled above-average total returns for the 60/40 blend in each of the time periods in the table (excluding the year after 1980) 

The federal funds target rate experienced significant declines within the each of the three-year time periods represented in the chart (with the exception of 1995-1997). Over just three months (March 31, 1980 to June 30, 1980), the rate plummeted by 10.5 percentage points, falling from 20% down to 9.5%. In the latter half of 1981 through the end of 1982 the rate fell again, dropping by 11.5 percentage points, from 20% on May 29, 1981 to 8.5% on December 31, 1982. As indicated in the table, the Federal Reserve’s (“Fed”) looser monetary policy acted as a catalyst, producing positive total returns for the 60/40 blend in all but one of the time periods represented.

Even after a 425 basis point increase in 2022, the federal funds target rate (upper bound) still sits below its historical average

The federal funds target rate averaged 4.89% over the past 50 years (12/29/1972 to 12/30/2022). As we discussed in Tuesday’s blog, 2022’s initial federal funds target rate was the lowest the rate had ever been at the start of such a steep tightening cycle. The resultant 17-fold increase in the federal funds target rate, while massive, only increased the rate to 4.5%. If the Fed is forced to tighten further, it is our opinion that the financial markets will continue to wallow. Conversely, the Fed does not have the cushion they did in the late 1970’s and early 1980’s should they need to loosen monetary policy.

Takeaway: The 60/40 blend posted positive total returns in nearly every one of the time frames represented in today’s table. Not surprisingly, the Fed was in the process of implementing looser monetary policy in almost every one of those time periods. 
We’re standing on a knife-edge. Further Fed tightening will add pressure to an already battered financial market. Conversely, the Fed cannot lower rates by the same 10.5 and 11.5 percentage points as the early 1980’s without adopting a negative interest rate policy.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance. The Bloomberg U.S. Aggregate Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

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View from the Observation Deck 

Today’s table highlights the last five times the Federal Reserve (“Fed”) increased the federal funds target rate (upper bound) by 200 basis points (bps) or more in a single calendar year. It also shows the level of the federal funds target rate at the start of the year and includes the total return of a hypothetical 60/40 blend. 

The federal funds target rate at the start of 2022 was an outlier
The federal funds target rate at the start of 2022 was substantially lower than any other time period in the table. In 1979 and 1980 for example, the federal funds target rate stood at an already elevated 10% and 14%, respectively, at the start of the year. Therefore, it was much less of a shock to the financial system when the Fed raised its target rate by 400 bps in each of those years. By comparison, the 425 bps increase in the federal funds target rate in 2022 represented a seventeen-fold increase over the 0.25% where the rate stood at the start of the year. The federal funds target rate has never been this low at the start of such a steep tightening cycle.

The 60/40 portfolio has had comparatively poor returns during the current rate hike cycle
Of the five calendar years represented in the table, 2022 was the worst year for 60/40 investors. So, what changed? In each tightening cycle listed above (excluding 2022), equities significantly outperformed their fixed income counterpart. In fact, the only year the S&P 500 Index posted a negative total return for the calendar years listed was 2022 (-18.13%). The negative returns equities suffered in 2022 reflect investors’ concerns over the unprecedented surge in the federal funds target rate over the course of the year, in our opinion.

Takeaway
The 425 bps increase in the federal funds target rate in 2022 represented a seventeen-fold surge over where the rate stood at the start of the year (25 bps). We’re in uncharted waters; we have never seen the federal funds target rate rise so quickly off of such a low floor. It is our opinion that the financial markets have yet to fully realize the impact of the Fed’s actions over the past year. 

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance. The Bloomberg U.S. Aggregate Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

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Technology and Communication Services companies lifted stocks to close out the week as the tech-heavy NASDAQ 100 Index rose almost 3% on Friday and 0.7% for the week. The S&P 500 and Dow Jones Industrial Average were both lower for the week but gained on Friday on the strength of the Energy and Tech sectors. Earnings season has just begun and leading the way on Friday was oilfield servicer Schlumberger with its quarterly print coming in above analyst expectations. The company reported a seven-year high in international revenue which could provide a boost for comparable Energy companies. Next week, 89 S&P 500 components are set to release quarterly results. Alphabet Inc, the parent company of Google, traded higher by almost 7% on Friday after news of job cuts to control costs stemming from leveling off of demand from advertisers and cloud services. Labor reduction is a trend in the technology sector after Meta, the parent company of Facebook, and Microsoft have also announced layoffs bringing the total tech cutback to over 200,000 jobs. More news coming from various Fed officials points to slower hikes as inflation could cool faster than expected. Patrick Harker, the President of the Philadelphia Federal Reserve, said he expects the central bank to “raise rates a few more times this year” and “hikes of 25 basis points will be appropriate going forward”. Looking ahead to next week, data on home sales, consumer sentiment, and jobs are all set for release along with more corporate earnings reports.  

Yields further inverted last week, as measured by the 3 Mo. - 10 Yr., which is natural as economic data deteriorates. The curve is intensely watched by the market for its history of anticipating economic contractions.  Also weighing on the market is the upcoming spectacle surrounding the debt ceiling.  Tangibly, however, there was much economic data last week and Wednesday’s releases included the Producer Price Index falling 0.5% on the back of falling energy and food prices.  Just don’t look at egg prices!  Retail sales fell for December and declining Industrial Production was registered.  Two housing reports were released last week, and both showed declines.  Friday revealed December’s Existing Home Sales fell 1.5% in December marking an eleventh consecutive month of declines primarily because of declining affordability from higher mortgage rates.  Housing starts fell in December for a fourth consecutive month all due to declining multi-unit starts.  There was a glimmer of hope in the housing start data as homebuilder sentiment, as measured by the NAHB Housing Index, rose to 35 in January from 31 in December. This is the first increase in thirteen months and ends the longest streak of declines since records began in 1985.  It is worth noting, though, that readings below 50 signal a builder view of conditions as poor versus good.  Major economic reports (related consensus forecasts, prior data) for the upcoming week include Monday:  December Leading Index (-0.7%, -1.0%) Tuesday: January Preliminary S&P Global US Manufacturing PMI (46.5, 46.2); Wednesday: January 20 MBA Mortgage Applications (N/A, 27.9%); Thursday: January 21 Initial Jobless Claims (205k, 190k), December New Home Sales (612k, 640k) and December Preliminary Durable Goods Orders (2.5%, -2.1%); Friday: December Personal Income (0.2%, 0.4%), December Personal Spending (-0.1%, 0.1%) and January Final University of Michigan Sentiment (64.6, unch.)

View from the Observation Deck 

• Small-cap and mid-cap stocks outperformed their large-cap counterpart in 2022 and the trend continues in 2023

To put it bluntly, U.S. mid and small-sized companies offer better valuations than their larger counterpart. The price-to-earnings (P/E) ratios of the S&P Mid-Cap 400 and S&P Small-Cap 600 indices were 14.81 and 15.20, respectively, as of 1/18/23, whereas the P/E ratio of the S&P 500 stood at 19.06. Comparing current P/E’s to their 10-year averages reveals an even larger disparity across market capitalizations. The 10-year average monthly P/E ratios for the indices in today’s table are: 20.31 (S&P 500), 21.74 (S&P MidCap 400) and 26.92 (S&P SmallCap 600). Even with their recent outperformance, mid and small-cap companies continue to offer an incredible value, in our opinion. 

• Sector performance can vary significantly by market cap

Technology stocks, which were the third-worst performing sector in 2022, made up more than 26% of the weight of the S&P 500 Index as of 1/18/23. For comparison, information technology comprised just over 12% and 13% of the MidCap and SmallCap indices, respectively. Similarly, the S&P 500 Index Health Care sector performed relatively well in 2022, but its mid-cap and small-cap counterparts suffered significant losses over the period (see the table above).

Takeaway: Valuations for the mid and small-cap indices are incredibly compelling, in our opinion. Mid-cap and small-cap companies outperformed large-cap names in 2022 and continue to do so in 2023 as investors take advantage of P/E ratios that are well-below their historical averages. If you aren’t already, it may be time to start thinking smaller!

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions and other expenses incurred when investing. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index of 500 companies used to measure large-cap U.S. stock market performance. The S&P MidCap 400 Index is a capitalization-weighted index that tracks the mid-range sector of the U.S. stock market. The S&P SmallCap 600 Index is a capitalization-weighted index that tracks U.S. stocks with a small market capitalization. The 11 major sector indices are capitalization-weighted and comprised of S&P 500, S&P MidCap 400 and S&P SmallCap 600 constituents representing a specific sector.

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View from the Observation Deck 
 
This chart is intended to provide an update on bond prices, which are typically sensitive to changes in interest rates. The dates in the chart are from prior posts. 

• All eight of the indices represented in the table show price improvements since 11/15/22

The Federal Reserve (“Fed”) remained steadfast in its commitment to battle inflation in 2022, raising the federal funds rate (upper bound) from 0.25% (where it stood in March) to 4.50% in December. Bond yields, which can be sensitive to interest rate movement, increased in response. This was reflected in price declines (bond yields and prices move inversely) in seven of the eight indices, as can be seen in the chart from mid-July to mid-November.
Conversely, bond prices recovered during the mid-November to mid-January time period. The Consumer Price Index (CPI), a common indicator of inflation, fell from 7.7% at the end of October to 6.5% at December’s end, giving some investors reason to believe that the Fed might reverse its policy of monetary tightening. The next Fed policy meeting regarding the federal funds rate is scheduled for February 1, 2023.

• Negative real yields (yield minus inflation) persist

As mentioned in our blog post from 1/10/23, most government bonds continue to pay negative real yields. Despite the recent rally in bond prices, investors should be aware that if inflation remains elevated above the Fed’s 2% target, bond valuations could be pushed lower. As of 1/12/23 only three of the indices in the chart have positive real yields. They are: the Morningstar LSTA U.S. Leveraged Loan 100 Index (9.01%), the ICE BofA High Yield Constrained Index (8.18%), and the ICE BofA Fixed Rate Preferred Securities Index (6.78%).

Takeaway: Recent price improvements in the U.S. bond market are a welcome sight, but bond investors would be well-served to watch the Fed’s next move carefully. Real yields are negative across most of the indices represented in today’s chart. If the Fed continues to tighten monetary policy, we may see further downward price pressures in fixed income, in our opinion.

This chart is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes and brokerage commissions or other expenses incurred when investing. Investors cannot invest directly in an index. The Morningstar LSTA U.S. Leveraged Loan 100 Index is a market value-weighted index designed to measure the performance of the largest segment of the U.S. syndicated leveraged loan market. The ICE BofA U.S. High Yield Constrained Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. The ICE BofA 22+ Year U.S. Municipal Securities Index tracks the performance of U.S. dollar denominated investment grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions with a remaining term to maturity greater than or equal to 22 years. The ICE BofA Fixed Rate Preferred Securities Index tracks the performance of investment grade fixed rate U.S. dollar denominated preferred securities issued in the U.S. domestic market. The ICE BofA 7-10 Year U.S. Treasury Index tracks the performance of U.S. dollar denominated sovereign debt publicly issued by the U.S. government with a remaining term to maturity between 7 to 10 years. The ICE BofA U.S. Mortgage Backed Securities Index tracks the performance of U.S. dollar denominated fixed rate and hybrid residential mortgage pass-through securities publicly issued by U.S. agencies in the U.S. domestic market. The ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. The ICE BofA Global Corporate Index tracks the performance of investment grade corporate debt publicly issued in the major domestic and Eurobond markets. 

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The S&P 500 moved 2.7% higher last week to close within a point of the 4,000 level. The index has closed higher on six of the nine trading days of 2023, returning over 4% to start the year. Consumer Discretionary and Technology stocks led all sectors, with Real Estate, Materials, and Communication Services also returning over 4% last week. Technology Stocks in the NASDAQ-100 climbed higher for the sixth straight trading session. One cause of the strong start to the year is investors’ view on lower inflation and how the Federal Reserve will act during the coming meetings. The December Consumer Price Index came in a 6.5%, which was in line with expectations. The cooling of prices as a result of higher rates sets the stage for the Fed to begin to talk about pausing rate hikes in the near future. On the other side of the rate policy is how it affects corporate earnings. JPMorgan reported on Friday and the company’s CEO Jamie Dimon weighed in on the current business environment. He cautioned, “we still do not know the ultimate effect of the headwinds coming” in with regard to persistent inflation and higher borrowing costs due to Fed policy. The University of Michigan Consumer Sentiment Index, a measure of consumer attitudes and expectations, surprised to the upside on Friday and lifted Consumer Discretionary stocks such as Amazon Inc and Etsy higher into the end of the week. Looking ahead, releases on retail sales, industrial production, and housing are all set for dissemination next week.