Stock prices declined for a third straight quarter as markets continue to assess the future prospects for inflation and interest rates. What makes this year so challenging is that bonds also have performed poorly. While U.S. and non-U.S. stocks have lost approximately one quarter of their market values for the year, intermediate-term U.S. bonds have declined by approximately -15 percent, and short-term bonds declined by approximately -5 percent.
The following anecdote will help to provide some historical context for this year. Wellington Management Company runs a mutual fund for Vanguard that traces its roots all the way back to 1928. Today, the fund is known as the Vanguard WellingtonTM Fund. WellingtonTM is one of the nation’s oldest mutual funds and the very first “balanced” fund. Balanced funds typically own a mix of stocks and bonds. If 2022 ended at the close of the third quarter, the fund’s decline of more than -20 percent this year would be the fifth worst calendar-year return in its nearly 100-year history. Only three years during the depression-era 1930s and the decline in 2008, during the Global Financial Crisis, were worse.
I want to highlight some significant changes this year in financial market conditions. Consider the following:
- Mortgage rates. The 30-year mortgage rate has shot up to nearly seven percent recently after beginning the year at around three percent. The negative impact on home price affordability is striking. A hew home buyer seeking a $350,000 mortgage near the beginning of the year would have paid approximately $1,500 per month in principal and interest on a 30-year fixed mortgage. The same mortgage today results in monthly principal and interest payments of approximately $2,300.
- Corporate bonds. Large public companies borrow money by issuing bonds. An index of investment grade bond issuers at the end of last year had a yield to maturity of 2.6 percent. Companies in this index include household names like Verizon, Capital One Financial, and CVS Health. More recently, the same index had a yield to maturity of 6.3 percent.
- Inflation-protected securities. The U.S. Treasury issues Inflation-Protected Securities (TIPs), which provide bond investors with a form of buy-and-hold inflation protection. At the beginning of the year, an investor in 10-year TIPs could expect to earn over the course of a decade approximately the annualized rate of inflation minus one percent. Today, 10-year TIPs offer an annualized return of the inflation rate plus 1.6 percent.
These examples show that the costs of accessing capital have increased considerably. Individuals must pay more to borrow for a home purchase, corporations now pay higher interest rates on new bond issues, and governments must do the same. The TIPs example demonstrates that this phenomenon is not just about additional compensation provided because of relatively high current levels of inflation. Recently, 10-year maturity TIPs had negative inflation-adjusted yields. This was a form of what economists call financial repression, which was beneficial to the government (cheap borrowing costs on government debt) but disadvantageous to savers (low interest payments on bonds). The TIPs market reflects not only a significant increase in inflation-adjusted yields, but importantly also a shift from a negative to a positive yield after inflation—an advantageous development for bond holders.
The significant declines in security prices this year impact future expected returns. The flipside of a higher cost of capital for those who need capital is a higher expected return for those who provide capital. Going forward, this situation likely is good news for you. We now expect higher returns, not just in lending markets, but across all asset classes in your portfolio versus our expectations coming into this year.
In the short run, we will have to live with more uncertainty. As we look out over the next several months, an escalation of the war in Ukraine, inflation proving to be more persistent than currently expected, and a looming recession are all possibilities. But uncertainty is always part of the investment landscape. Generally, the rewards from investing are greater when the environment seems unusually unstable or risky. This time should be no exception. In our judgment, the prospective long-term returns for multiple-asset-class portfolios are greater today than at nearly any other time in the past decade.
We are available to discuss how the developments this year impact you and your strategy. As always, we welcome and look forward to our next conversation.
- Loosely defined, a “safe” withdrawal rate is an amount that an investor can reasonably expect to withdraw annually through retirement without depleting his or her portfolio.
- Bengen, William P. Determining Withdrawal Rates Using Historical Data. Journal of Financial Planning. October 1994.
- A caveat to this statement involves time horizon and cash flows. Investors with long time horizons, who are regularly contributing to their portfolios, will be better in the off in the long run as a result of a price decline. Shorter-time horizon investors and those who are taking distributions from their portfolios may be relatively worse off after a price decline.