By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
November 11, 2022
This year may go down as one of the worst years on record for a fully-invested balanced (60% stocks, 40% bonds) portfolio, which has seen a combined decline of 20% as of last Friday. Though we at our firm have not been fully invested throughout this year—holding a sizeable cash position—it’s important to understand just how poorly the traditionally safe, fully-invested 60-40 portfolio has performed so far this year relative to history. Bonds typically offset losses in the stock market but, instead, this has been the worst year for widely held US 10-year Treasuries since 1788!
Year-to-date, the combined losses of a fully invested 60-40 balanced portfolio are now within comparison to the 1907 panic where the New York Stock Exchange fell 50% and J.P. Morgan corralled other banks to shore up the banking system, the 1931 Great Depression, and the financial meltdown of 2008. Think about that for a second, a fully invested 60-40 balanced portfolio is down a similar amount than what we saw during a major banking crisis, the Great Depression, or during the financial collapse of 2008.
Looking at the stock market alone, this is the sixth worst year on record where the only years in which stocks performed worse were in the years mentioned above and the 1974 recession induced by the 1973 oil crisis. What has really cut deep into balanced portfolios in 2022 has been the performance of bonds, which are posting their largest decline ever, with data going back to 1900. Through last Friday, the normally stable and less volatile 10-year US Treasury bond was down 19% so far this year, which is nearly unheard of. To put this in context, the second worst year for bonds over the last 122 years was in 1994 when bonds were down 9%. This year is literally more than double the decline of the prior worst year on record. One of the worst years for the Dow Jones Industrial Average was the 53% decline during 1931. Imagine double that decline, which isn’t even possible, but it gives you some sense as to how badly bonds got hit this year.
That Year that Bonds Failed
When constructing a balanced portfolio, the role bonds play are to serve as the ballast of the portfolio to help stabilize returns for a smoother path and lower drawdowns. Going back to 1926, bonds have served this function well where between 1926 through 2018, in the 25 years in which stocks fell, bonds were up in 23 of those years to lessen the hit from a falling stock market. During that 94-year period, bonds suffered only twelve negative years, which is roughly once every eight years, while stocks fell once every four years. This tendency of bonds to stabilize stocks is shown below, coming from data compiled by Fidelity.
While the S&P 500 serves as the predominant benchmark for stocks, the Bloomberg Barclays U.S. Aggregate Bond Index (AGG) is the predominant benchmark for bonds, which was created in 1976. Fidelity created a synthetic benchmark with returns going back to 1940 and, between 1940 and 2018, bonds posted eleven negative calendar year returns where the worst decline was 3.2%.
Through last Friday the 4th, the Bloomberg Bond Index is down 16.02%, which is five times worse than the worst prior return in the last 80 years. Instead of cushioning the blow from a falling stock market, bonds have added salt to the portfolio’s wounds.
Our firm’s proxy of the balanced stock-bond portfolio is our Growth with Income (GWI) objective, which has a benchmark of 60% stocks and 40% bonds. We are active managers and can increase or decrease our allocation to both stocks and bonds depending on our read of the market environment. Late last year we were anticipating a withdrawal of market liquidity from global central banks as well as decelerating growth from the rapid pace of late 2020 and 2021. In addition, we took odds with the Fed’s “transitory” argument that inflation would subside and felt inflation would only accelerate into 2022. Consequently, we began to raise cash for clients in the final month of the year as well as build a position in precious metals. At no point in 2021 did we ever come close to a neutral 40% bond allocation (dashed yellow line below) and were underweight bonds in our other objectives as well.
To start this year, we had nearly half of our benchmark’s 40% allocation to bonds at 21.7% and kept the balance in cash. As the year wore on, we transitioned from believing we would have a growth slowdown to an outright recession based on the acceleration in inflation that surprised to the upside and a more aggressive Fed than was anticipated. We then had a negative quarter for economic growth in which real gross domestic product (GDP) fell -1.6% in the first quarter followed by a consecutive decline of -0.60% in the second quarter, meeting the textbook definition of a recession with back-to-back negative quarters of GDP. To further the recession argument was a yield curve inversion (when short-term rates are higher than long-term rates) of the 10-year and 2-year US Treasury yield, which has been a harbinger of a coming recession.
We felt it was wishful thinking that the U.S. would skirt a recession with the most aggressive central bank hiking cycle since Fed Chairman Paul Volker in the 1970s. The investment playbook for a recession is to sell stocks and commodities and buy bonds. However, we kept our commodity exposure due to our views on energy and precious metals as well as kept our allocation to stocks, but below our target benchmarks. When it came to bonds, given that no other asset class has provided better returns in the last six recessions and in light of the unprecedented decline they’d seen the first four months of this year, we used this as an opportunity to increase our bond exposure by making several purchases between May and July via the iShares 20+ Year Treasury Bond ETF (TLT). By the middle of July, we had a modest overweight to bonds at 45% as shown below:
In our last client letter, we presented the investment case for why we purchased TLT for clients given that, for the last 40 years, interest rates peaked before the onset of recessions and bond prices typically rallied. However, as we pointed out, during long-term trends of rising inflation and rising interest rates, unlike the past 40 years, interest rates tended to peak during the recession, not before. In light of our view that a recession was still on the horizon, we held onto our position in TLT with the expectation that bonds would rally as a recession approached.
What Has Changed?
As most of our clients are aware, we began to cut our exposure to TLT last month with our final sale last Friday. While we know that inflation is high, we are now seeing trends that weren’t even present in the 1970s. For example, during the 1974-1975 recession, interest rates peaked ahead of the peak in inflation as they did in the 1980 recession as well as the 1981-1982 recession. In this cycle, the headline inflation rate peaked in June at 9.1% but has since seen four consecutive monthly declines to 7.7% in October. Even with four months of lower inflation readings, the 10-year US Treasury yield hit a new high last month of 4.34%. With inflation now four months off its highs, why haven’t bond yields fallen as well, when even in the 1970s they peaked before the peak in inflation? There most be something else to explain what is going on and it boils down to Economics 101: supply and demand.
Currently, the US Treasury (UST) is issuing $1.47T in new debt on a trailing twelve-month basis. Outside of the COVID downturn, the last time the US issued that much debt was back in 2009 when the unemployment rate was north of 10%, not the current 3.7% we have now. The UST has been issuing high rates of debt ever since 2020 and the reason why this hasn’t been a problem until this year was due to the purchases made by the US Federal Reserve in addition to foreign central banks and US commercial banks. Year-to-date, US commercial bank ownership of USTs has fallen by $204B, the Fed has reduced its holdings by $196B, and foreigners have likewise pared back by $86.5B. Looking at just these three groups shows a decline of nearly half a trillion dollars in holdings while the UST is issuing nearly $1.5T on an ongoing basis. The Fed has been shrinking its balance sheet to tighten monetary policy, US commercial banks are selling their assets to meet the outflow of funds from depositors, and foreign central banks are selling to help prop up their currencies, many of which are in freefall. Just about every single currency is down relative to the USD in the last year except for a few South American currencies and the Russian ruble, which is up 15.3%.
While interest rates may fall for a few weeks at a time, we are concerned that we haven’t seen the peak in interest rates, which is what finally prompted us to exit TLT. For example, over the last forty years, whenever the Fed raised interest rates, the 2-yr UST yield peaked above the final rate hike by the Fed. On average, it peaked 1.1% above the final rate hike and as low as 0.2% above and as high as 2.7% above. Currently, the high for the 2-Yr UST yield is 4.72% and the market’s estimate for the Fed is 4.9% by June 2023. While this time may be different, history argues the 2-year rises at least to 5%, if not higher.
Despite a high probability of a recession around the corner, unlike prior recessions in which interest rates fall during recessions, we could easily see them rise as they did in the recessions of the 1970s. Further, should the US fall into an economic contraction next year, we are likely to see tax receipts fall and government spending pick up to pay unemployment claims, which would only further exacerbate the deficit and force the UST to issue even larger amounts of debt. All the while the US Fed continues to shed its holdings of USTs as do foreigners to stabilize their currencies. Additionally, as long as the average deposit rate paid by banks remains less than a tenth of a percent, depositors are likely to continue to pull their funds to invest in money markets and T-bills in which they can earn a superior interest rate which in turn forces banks to sell even more assets. In short, we continue to see the supply of US debt outstripping demand which should pressure interest rates even higher.
Potential 'Doom Loop' Coming to the US?
What has disturbed us and led to the final sale of TLT was the Treasury’s borrowing announcement made on Halloween. Ever quarter, the Treasury issues its estimated borrowing needs for the present and next quarter, and estimated in August that it would issue $400B in debt in the fourth quarter and on Halloween they raised their estimate to $550B, or 37.5% higher. The Treasury also mentioned they estimated their “checking account” at the Fed would end the year at $700B. For the first quarter of 2023, they estimate they will borrow $578B through debt issuance as well as draw down their bank account at the Fed by $200B for a total spending of $778B in a single quarter.
So, we went from the UST estimating it would spend $400B in the fourth quarter to revising that to $550B and then they estimate they will spend $778B in the first quarter of next year. The US Treasury is telling us they plan to spend $1.33T in excess of revenues on a six-month basis which comes out to $2.66T on an annual basis, and that is assuming the economy continues to hum along without a recession!
Whenever we have seen a massive increase in UST debt issuance where foreigners were not heavy buyers, the Fed has stepped in as a buyer of last resort. They have not done that this year, which has led to one of the largest spikes in interest rates seen in less than a year. During 2021, the UST issued $1.5T in debt when the Fed purchased just shy of $1T or two thirds of all debt issuance. Currently, the Fed is shrinking its UST holdings by $95B a month which comes out to just less than $1.2T. So, in contrast to 2021, when the Fed bought nearly $1T in US debt, they are looking to reduce their holdings by around $1.2T in 2023 while the US Treasury is set to annualize its debt issuance to $2.66T…Washington we have a problem! This is exactly what the former US Treasury Secretary Larry Summers warned about last month.
Larry Summers warns of a dreaded economic ‘Doom Loop’ and says America should pay close attention to the UK’s troubles
Former Treasury Secretary Lawrence Summers said that policy makers in the US and elsewhere should heed the fiscal lessons from the UK’s recent crisis, and not assume Britain’s troubles were unique.
“That would be a real mistake” to conclude that other countries wouldn’t end up confronting similar challenges, Summers told Bloomberg Television’s “Wall Street Week” with David Westin. The first lesson from the UK is “that things can change extraordinarily fast.”
Governments need to pay increasing attention to their budgets, with mounting deficits alongside surging borrowing costs having the potential for shaking confidence, he said. In the US, student-loan forgiveness, emergency funding for Hurricane Ian and rising defense spending needs suggest that fiscal debates will need to be “back on the table,” he said.
“If your deficit projection starts to get out of control and your real interest rates start to rise rapidly, you can get into a kind of doom loop,” said Summers, a Harvard University professor and paid contributor to Bloomberg Television. “We’re going to need to be watching our own fiscal projections in the United States very carefully…”
Summers said that a further risk stemming from government debt markets is the concern with deteriorating trading conditions. He endorsed Treasury Secretary Janet Yellen’s recent expression of concern over a “loss of adequate liquidity” in US Treasuries…
“Unfortunately, I think we fired the fiscal cannon so strongly that there’s going to be limited room for discretionary fiscal policy if we have another recession,” he said. (Emphasis added)
As we mentioned earlier, debt issuance north of $1T has been associated with recessions and high unemployment rates. Should the US economy slip into a recession as we expect, the Treasury will have to issue significantly higher amounts of debt as tax receipts plummet and unemployment spending goes up. Washington’s excessive spending during an economic expansion severely constrains its borrowing abilities during an economic downturn, which could ultimately lead to one of two outcomes: interest rates rise during a recession as supply overwhelms demand for US debt or the Fed comes to the rescue. A third potential outcome is that rates spike first and unravel markets, which then forces the Fed to step in, likely driving down the USD and generating a further spike in commodities and pressuring inflation rates back up. We saw the Fed do this in 2019 during the repo crisis in which problems in the US financial plumbing system arose where the Fed went in less than a week from selling USTs to buying them. It is highly likely that when push comes to shove, the Fed will be forced to step in as the buyer of last resort as we have already seen the Bank of England do a few months ago as well as the Bank of Japan.
Should the Fed step in and begin to expand its balance sheet once more, it will likely be doing so with the highest inflation rates seen during quantitative easing (QE) programs. During QE 1 in 2009, the CPI inflation rate averaged -1%. During QE 2, the inflation rate averaged 2.3%. During QE 3, the inflation rate averaged roughly 1.6%. With an annual inflation rate currently at 7.7%, it is quite likely should the Fed embark on another round of QE, that inflation is likely to be 2-4 times as high as during prior episodes of QE.
Outlook & Portfolio Strategy
With the positive surprise to October’s CPI report, the markets surged on hopes of a milder Fed response to inflation with smaller rate hikes. It is quite possible that November will go down as the last 0.75% rate hike by the Fed, but we are still likely to get a 0.50% rate hike in December followed by more 0.25% hikes to come after that. This means the official “pivot” in which the Fed stops hiking interest rates is not likely to occur until late in the first quarter of 2023 or possibly into the second quarter. Essentially, short-term interest rates will continue to rise and will likely stay elevated, as the Fed has suggested, until inflation moderates to their long-term target of a 2% annual inflation rate.
With November and December historically being the two strongest consecutive quarters of successive buybacks and that 2022 is likely to see the largest amount of buybacks ever, there is a lot of cash on corporate balance sheets that will likely be spent between now and year-end and, with sentiment so bearish, the stock market is likely to have some legs to it. This is why we have built back our allocations to stocks to a neutral level relative to our benchmarks after being underweight all year.
However, we still continue to see daily announcements by corporations laying thousands of workers off (“Wells Fargo mortgage staff brace for layoffs as U.S. loan volumes collapse”) as well as the housing market likely to continue to weaken with elevated mortgage rates. These trends are why we continue to feel a recession awaits us in 2023 and, with it, the likelihood of renewed selling in the stock market and, as mentioned above, a possible resurgence in bond yields should tax receipts fall and unemployment claims rise, leading to a further deterioration in the budget deficit. Should our outlook play out, we would look to move back towards a defensive posture by reducing our exposure to the stock market, raising cash, and waiting for the Fed to bail out financial markets next year and step in as the buyer of last resort.
If the Fed comes riding to the rescue and we still have an elevated inflation rate, we could very well see a sharp decline in the USD and a surge in commodities. Our various benchmarks (used to assess performance), as well as most advisors in our industry, have zero exposure to commodities and are thus ill prepared to handle inflation and higher commodity prices. However, we have built up our commodity exposure starting last year and, should market volatility afford us the opportunity to buy commodities on weakness, we plan to further increase our exposure for clients. This move towards commodities is to hedge our clients against what Elliott Management and we see as a difficult period ahead for the passive buy-and-hold investor who shuns commodities at their own risk.
Should you have any questions, please do not hesitate to reach out to your wealth manager and we hope you have a wonderful Thanksgiving.
Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.
Copyright © 2022 Chris Puplava