June 30, 2021 – Daniel Zalipski, CFA®
From an investor’s perspective, the coronavirus is in the rear-view mirror as the direct economic impairment from the pandemic fades away. Attention has mostly shifted to the interconnected topics of the Fed, jobs, wages, and inflation.
At some point, the Fed will reduce their accommodative policies set in place to address the unprecedented environment brought on by the pandemic and subsequent restrictions. Should economic data surprise to the upside, the Fed may have to respond earlier than anticipated. The concern is that with less Fed support, the market may be more volatile and susceptible to economic weakness. The Fed is expected to remain patient and telegraph their moves far in advance as to not cause panic within the markets. Current consensus is that the Fed will announce a policy shift later this summer expected to begin in the first half of 2022.
With the incredible run the market has had since the onset of the pandemic, our advisors are asked if now is the time to reduce risk by trimming exposure to the equity markets. It is a valid question to consider, but the answer may not be as straight-forward as expected. Every situation is different and the answer to that question is largely dependent on the individual investor.
For the purpose of this exercise, let’s consider equity, fixed income, and cash as the three primary asset classes within a long-term investor’s portfolio. These three are in a never-ending battle to attract investment dollars, with each having their own unique characteristics defining their potential risks and returns. A decision to sell one asset class is also a decision to buy some other asset class. Reducing equity exposure would suggest increasing fixed income or cash.
Fixed income, or bonds, are often thought of as being ‘safer’ than equities. They are typically less volatile than stocks, and at times will move in opposite directions from stocks, providing an element of ballast to portfolios. The U.S. Treasury has long been considered the world’s ‘safe haven’ asset, the place everyone goes to hide when the equity markets sell-off. Treasuries, however, are very susceptible to interest rate risk. As interest rates rise, treasuries’ price declines. In the first quarter of 2021, the yield on a 10-year treasury increased from 0.91% at the start of the year to 1.74% by quarter-end. During that same time period, the price of those same treasuries declined nearly 6%. For a fixed income instrument paying less than 2% a year, a 6% hit to price could potentially take several years to recovery. Rates are likely to experience upward pressure as the Fed reduces their accommodative policies, which could push prices lower for a variety of fixed income securities susceptible to interest rate risk.
Low rates are pushing down yields on fixed income, but they are doing even more damage to cash. For more than a decade now, my personal savings account at a big nationwide bank as paid an annual interest rate of 0.01%. Certificates of Deposits are not much better; there are some paying 1% if you lock-in for 5 years. With such low yields, you are all but guaranteed to lose on an inflation-adjusted basis. There’s concern that stimulus enacted in response to the pandemic, combined with the pent-up demand associated with reopening will increase inflationary pressures within the economy, further eroding the buying power of cash. In addition, the Fed has signaled its willing to tolerate higher inflation relative to past cycles as they pursue full employment. In other words, cash could experience an even larger drag from inflation than the past decade.
Equities are expected to continue to benefit from the pent-up demand associated with reopening and relaxing Covid restrictions. Consumers are flush with cash due to a year of government stimulus efforts and support for the unemployed. Equities can carry less interest rate risk than bonds, with some sectors even benefiting from rising rates. Furthermore, these public companies can adjust for inflation by raising prices. Valuations appear elevated, and volatility is to be expected, but equities still offer a reasonable potential return given the risks and market environment. Every investor’s situation is unique, and allocation decisions should consider a wholistic view, and are best discussed with your wealth advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to, nor does it represent or reflect, transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.