Q2 2022: The Effects of Rising Interest Rates

by | Jul 11, 2022 | Market Commentary

June 2022: Bear market in *almost* everything

So far in 2022, rising interest rates have impacted all markets negatively. There is a re-pricing happening at higher rates that is causing corrections for almost every major asset class. The effect on the hyper-growth stocks has been notable. As a group, they are down over 70% from their 2021 highs. Energy stocks are the one and only winner.

Rising interest rates and inflation making multi-decade highs served as a bucket of cold water waking up investors to the fact that a vivid imagination is not the only skill required to be an investor.  Declines of some of the well-known, high growth, tech stocks have been staggering since they peaked in 2021. 

Second Quarter 2022 Market Review

Selected capital market returns for the period ending June 30, 2022.

Higher interest rates mean investments expected to pay off in the distant future don’t look so attractive in today’s dollars anymore. The emphasis has shifted to current value rather than far-off-in-the-future-value. That’s because the discounting factor has gone up.

Needless to say, the markets are unsettled and volatile. So, let’s take a look at what’s driving rates higher, and causing the market volatility.

What’s going on with bonds?

When interest rates rise, bond prices drop. Think of the relationship like a seesaw. On one end are interest rates, on the other end are bond prices. As rates rise, bond prices drop. And, as rates drop, bond prices rise. Since February 2022, interest rates have been rising fast.

First, the Federal Funds Rate has lifted off zero. As of June 29, 2022 it reads 1.58%. A mere 6 months ago, it was only 0.08%. This affects short-term rates from auto loans, money markets, and credit cards. When you hear about rate decisions from the FOMC committee meetings, this is what they are talking about.

Second, the Federal Reserve is going to begin shrinking its balance sheet starting June 2022. After pumping incredible amounts of liquidity into the system during the 2020 Covid-19 market panic, they are now taking it away. The effect is higher long-term rates. In fact, the national average for a 30-year mortgage has jumped to 5.70% as of June 30, 2022 from 3.11% 6 months ago. According to J.P. Morgan estimates, $2.2 trillion of assets will be eliminated from the Federal Reserve’s balance sheet by the end of 2024.

Bear markets are a normal part of investing

When asked, most investors think of market volatility as a chart with sharp up and down lines. The violent downturns and sharp upturns seemingly have no rhyme or reason. A lot of it is just plain noise. Zoom out and you’ll see that the markets have survived a wide variety of wild events. Turns out, volatility is normal.

From 1926 through 2021, the S&P 500 Index experienced 17 bear markets, or at least a fall of 20% from a previous peak. Bear markets have shocked markets every 7.7 years on average. The declines range from -21% to -80% and last around 10 months. On the upside, there were 18 bull markets, or gains of at least 20% from a previous trough. They averaged 55 months, and advances ranged from 21% to 936%.   

Volatility can be a wild ride

Looking at the last 40 years, intra-year volatility has been dramatic at times for the US stock market. Breathless news commentators, gasping at the latest market sell off serve no function.  The indices highlighted on the nightly news may not even be relevant anymore.

A diversified portfolio can ease the pain

No one knows which markets or asset classes will perform well from year to year. By holding a properly diversified portfolio, you position yourself to capture returns wherever they may occur. Since the Great Financial Crisis, a diversified portfolio has smoothed the volatility by never being the worst performer.                                                                                           

Staying invested through it all is critical

A disciplined investor looks beyond the concerns of today to the long-term growth potential of the market. Despite seeing bull markets interrupted every 7.7 years on average, $10,000 invested in the S&P 500 at its inception would now be worth over $140,000,000. Owning pieces of the world’s greatest companies helps build real retirement wealth. Playing the long-game has paid off.

Don’t even think about it – trying to time the market that is.  It’s seductive, and compelling, but missing even a few of the market’s best days can dramatically impact returns.  In the last 20+ years, 21 of the 25 worst trading days were followed, within a month, by one of the best trading days.

Matching portfolio risk to cash flow needs

Over-time, a continuously invested bond portfolio will overcome volatility due to regular coupon payments. That’s why we stress matching portfolios to cash flow needs. If you own bonds that are expected to mature in 5 years, match those to expenses expected to be incurred in 5 years. If matched to 1-year goals, you may have to take losses to spend your money. In fact, we like to recommend at least 3-5 years in cash and ultra-short, ultra-safe bonds for near-term spending needs.

Higher rates and dropping bond prices don’t feel good in the short-term. However, the silver lining is that portfolios will soon be earning more income. And for those that felt forced into stocks for yield, this is great news, soon we may be able to layer more bonds back into portfolios. Check your personalized investment objective letter with your reports this quarter.

An unsettled market is never comforting. Nevertheless, as long as you have a financial plan, with a sound investment strategy to meet your goals, just stay the course. When implemented, we believe clients can still retire confidently and comfortably despite ugly market conditions. If you want a retirement check-up, please let us know. We’re here to help!

The Team at Wright Associates


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