Another day, another set of record highs for the major averages. Yesterday’s action was led by cyclical sectors again as Energy, Industrials and Consumer stocks posted solid gains. However, markets closed near the lows of the day on reports that Pfizer is having production issues with their vaccine. No one should expect a straight line up or distribution concerns to go away. This is a massive feat, especially considering the storage requirements for some of these treatments. After a spike higher in stocks like we saw in November, back and forth action is positive as it feels like a bit too much optimism has crept back into the markets.
Prior to this, investors continued to look past the dire Covid numbers in the US and are pricing in a much brighter 2021. Estimates for a return to normalcy keep getting pulled forward. It won’t be easy, but a huge part of the global population will have access to various treatment options by Spring. Every month of shots gets us closer to herd immunity. What was once a question mark is on the way to becoming a reality. The UK is a start. It looks like two vaccines will be approved by year-end in the US. There are several others we expect to be approved early next year as well. Futures are taking this in stride this morning with most averages attempting to break new highs again.
We have discussed the numerous tailwinds that are forthcoming. A lot of that good news was priced in the markets last month. The S&P is now up 14% on the year with the Nasdaq over 35%. Investor’s asset allocations are likely getting out of whack as stocks staged a massive rally. But, do they want to readjust?
This brings us to the fixed income world. The most pressing question we receive is what to do with bond exposure for accounts that want income. In a world where every 3%+ coupon bond is being vulnerable to being called, investors are stuck with difficult alternatives. Do they buy a 5 year corporate bond with 1% yield? Do they extend their duration to 10 years and get 2%? Do they go out on the risk curve and buy junk bonds to get 3%? None of these are attractive options to say the least.
Let’s stick with 10 year Treasuries to keep it simple. Yields peaked all the way back in 1981 at nearly 16%. Outside of some cyclical pops, it has been a straight line down, until the pandemic lows of 0.40%. Today, we’re at 0.92%. Anyone buying a 10 year Treasury is basically locking in a loss of purchasing power until 2030. In round numbers, inflation is 2%. Every year of 1% returns means your dollar loses 1% of purchasing power, annually. They still belong in portfolios but only as a vehicle for safety and to lower volatility. Holding Treasuries for the next 10 years is not a way to grow your assets.
The old adage is that everyone should keep their fixed income allocation in line with their age. A 65 year old should have 65% of their assets in bonds and 35% in riskier areas like stocks or real estate. This was based on decades of research and a likelihood of drawing down on their account. Most retirees can withdraw 4% annually and expect to outlive their assets, assuming historical returns hold up. You also want certainty with respect to stable asset levels and more fixed income does that for you. In a previous world of 4% – 6% yields, this made a lot of sense. However, when you lock in 65% of your assets in a vehicle generating 1% returns at today’s rates, it becomes onerous. One might say its riskier today to rely on bonds over equities or you may outlive your nest egg.
After a nearly 40 year bull market, many investors have never seen a true fixed income bear market. Most have never seen more than a year of flat or negative returns. Looking forward from here, all signs point to a likelihood of that changing. Treasury yields finally breached their 50 and 200 day moving averages, a sure sign of strength. The US Dollar is down substantially this year relative to the world. That leads to rising prices for US spenders and is inflationary. Money supply is running wild as Fed balance sheets explode. The four largest banks in the world increased their balance sheets by 70% in just a few months. They are still expanding. Shipping rates are up with FedEx and UPS raising rates. Supermarkets are in high demand, allowing them to raise prices. Home values are skyrocketing in the suburbs. Inflation is all around us and we’re not even back to normal life.
Jobs came rushing back to the market and most of them are for skilled labor. Many low wage earners are not coming back to the same position. Gone are McDonald’s# cashiers, replaced by computer screens. Home Depot# and WalMart# get more sales via their self-checkout lanes than regular ones. Online ordering means fewer people working at the malls for $8/hour. Restaurants are doing more with less. Technology has been the ultimate driver of eliminating low-wage positions. When the labor force is retrained, they are coming back to $15/hour openings and high-tech jobs. This should lead to higher wages over time. Historically, wage increases of 4% lead to rising inflation. When inflation rises, yields rise. When yields rise, bond prices come down.
Any investor paying par ($100) for a 1%, 10-year Treasury today could see that price drop precipitously over the coming years if the inflation story takes hold. If the 10 year yield rises to 2% next year (which is where yields were just 12 months ago), that same bond purchased at $100 will be worth $91. Investors holding that bond will still get 1% in coupons annually, but will have already lost 9% of their purchasing power in a year. Things get even worse if inflation hits the Fed’s targets for over 2% on an extended basis.
What to do?
- Keep maturities shorter than usual. Don’t lock in horribly low rates unless you have to. Investors who are risk averse and do not have the stomach for daily gyrations in equities should remain invested in fixed income.
- Be selective. Special opportunities arise in fixed income just like equities. Plenty of bonds were trading well below fair value this year and another chance will arrive in time. Wait for a good entry point.
- Shift some portion of your fixed income towards stable, high dividend paying stocks. Companies like Johnson & Johnson#, Coca Cola#, Bristol Myers# or Verizon# yield 3% – 4%. None of them are going out of business over the coming years and they grow their dividends. If you can hold for 5 years, it is likely you get some principal appreciation to boot.
- Wait it out. Stay in cash and earn nothing for a bit. This seems like a better option than potentially losing principal on bond prices if/when yields do finally rise.
- Don’t fret over the income levels. Unless you are an income beneficiary of a Trust, investors can focus more on their total return instead of pure income levels. High quality growth companies like Google#, Facebook# or even Berkshire Hathaway pay zero dividends but have generated double digit gains over the past decade plus. One should much prefer a double digit returning stock over one that pays 4% a year in dividends but has minimal growth characteristics. Income levels should be taken with a grain of salt when the overall portfolio is handily outpacing its spending rate.
These are not easy decisions to make. All come with added risk that bond investors did not have to deal with in years past. Covid – induced declines in yields, worldwide, are causing continual pain for income dependents. Here’s hoping the bull case plays out from a Covid vaccine standpoint and we can discuss a more normal market next year in bonds and equities alike.
Shawn Carter, better known as Jay-Z, is 51 today. Tyra Banks is 47. A confusing movie could be made with Fred Armisen, 54, Jeff Bridges, 71, and Marisa Tomei who turns 56.
James Vogt, 610-260-2214