Editor’s note: Christopher Baccella is a longtime columnist with Rethinking65. Read more of his articles here.
What a difference a few months makes! When I wrote my last article for Rethinking 65 in late December, yields had fallen significantly, and investors were under the impression that the Federal Reserve would soon begin a series of interest rate cuts. Instead, yields have climbed, changing the financial calculus for investors. Today’s rates, combined with a strong performance from the stock market, present an opportunity to review your clients’ asset allocation and risk tolerance.
As clients approach and move through their retirement years, they typically move a greater portion of their assets to “relatively safe” investment-grade fixed income. Today’s higher yields on bonds mean they can afford to “de-risk” their portfolio while still generating attractive returns.
Before diving into how to do this, let’s look at where we are and how we got here.
Since 2022, the Federal Reserve has tightened the federal funds rate by 525 basis points and reduced its balance sheet (securities it holds) by nearly $1.5 trillion in an attempt to slow economic growth and reduce inflation. This quantitative tightening caused rates to spike to a level some economists believed to be unsustainable.
In December, I noted that “… the bond rally has overshot, and yields will likely find support around current levels.” Yields on 10-year Treasury bonds, which had peaked around 5% in late October, had at that time sunk to about 3.75%.
But markets love to defy expectations, and over the last four months rates have moved meaningfully higher. For example, 10-year Treasury yields closed out April nearly a full percentage point higher, at 4.7%. Yields on callable agencies have also advanced, and we’ve begun to see new-issue government-sponsored agencies (GSAs) coming to market above 6.0%.
The Real Deal
So, what triggered this reversal? The bond market (and perhaps equities as well) got ahead of itself. When the Fed released “dot plots” showing it expected to cut rates three times over the course of 2024, market participants quickly began to price in additional cuts. Like the Fed, investors believed inflation was now a thing for the history books.
Additional Reading: The Perils of the Fed’s Vast Bond Holdings
But reality bites, as the saying goes, and many doves were forced to acknowledge reality when the Consumer Price Index (CPI) remained stubbornly strong. For example, March CPI rose 0.4%, up 3.5% from a year earlier, while the Core (ex-food and energy) remained unchanged at +3.8% from year-ago levels.
Not only did inflation come in higher than expected, but it’s also well above the Fed’s inflation target of 2%. Investors have quickly come to the realization that we are again in for a period of higher interest rates for longer.
Let’s not forget the big picture, either: Most equity markets are coming off a stellar 2023 and first quarter of 2024, but stock momentum may be slowing (more on this in a second). For those clients who are overweighted in equities, or prefer to de-risk their portfolios, this combination of higher yields and strong stock prices presents an opportunity to take some profits and rebalance into investment-grade fixed income.
Equity Essentials
As for the equity markets, the Standard & Poor’s 500 increased 26% in 2023 and gained another 10.6% in the quarter that followed. Much of those gains were generated by the so-called “Magnificent Seven” tech stocks and/or companies associated in some way with artificial intelligence (AI).
While gains are great, they can lead to concentration and valuation issues. And of course, any fan of Western movies knows that at some point the good guys ride off into the sunset. Or, using a sci-fi analogy, we’ve all seen stocks “round trip” — generating explosive gains in a short period of time, only to come back to earth (sometimes violently) when growth can’t match expectations. For example, some work-from-home stocks that exploded during the pandemic era crashed by early 2022 when earnings failed to match expectations.
As Benjamin Graham, known as “the father of value investing,” famously quipped, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
It’s also worth pointing out that most major equity indices have recently broken below their 50-day moving average. This applies to the Dow Jones Industrials, S&P 500, Nasdaq Composite, S&P 400 (mid-caps), S&P 600 (small caps), EAFE (Europe, Australasia and the Far East) and Emerging Markets. Stock market momentum may be slowing. Additionally, geopolitical risks have increased significantly, especially in the Middle East.
Client Opportunities
The good news is that today’s higher interest rates reduce the opportunity costs of seeking safety. With many money market funds paying more than 5% and bond yields at that level or higher, clients can afford to reduce their equity exposure.
For those clients who are hesitant to sell their winners, I’ve often found that they are willing to “take their cost out.” For example, a client invested $10,000 into a Magnificent Seven or AI company a few years back. That investment is now worth $100,000 and may present a concentration issue. By selling $20,000 of the stock, the client has removed their cost from the investment while keeping enough aside to pay the capital gain taxes, set aside some spending money and reduce their concentration. One advantage of this approach is they are now playing with “house’s money” and may be less nervous about volatility.
The downside of higher interest rates is that many fixed income mutual funds are heavily in the red. Capital losses on these bond funds can be used to offset gains on the equity side of their investment portfolios. There’s no need to wait until year-end to do some tax-loss harvesting.
Christopher Baccella, CFA, is a wealth advisor with Mariner Wealth Advisors. He develops personalized wealth management solutions to help wealth-management clients achieve their goals and grow and protect their wealth. He also provides investment management services to institutional clients. Chris has over 16 years of experience in the wealth management industry. He can be reached at chris.baccella@marinerwealthadvisors.com. Click here for disclosures.
