Mid Quarter Client Investment Update

Periodically we ask ourselves a common client question, whether verbalized or in their thoughts: “What are reasonable return expectations for bonds and stocks in the next one, five, ten or more years?”. This writing will address this question, as well as “What are ‘normalized’ interest rates?” To provide responses to these questions, we start with a review of relevant data points, currently and in recent years.

Interest Rates and Bonds

Yields on U.S. Treasury securities have risen recently with the 2-year rate at 4.99%, the 10-year rate at 4.34%, and the 30-year rate at 4.47%. After a decade of near zero and negative interest  rates, combined with getting bruised in 2022 in both bonds and stocks, the ability to earn 4% to 5% on short-term securities that are safe and liquid is very attractive.

Indeed, we have moved appropriate account assets into short-term investments to garner attractive returns. The 10-year rate has not been this high since 2007 and it was in 2011 that the 30-year rate was last at today’s level. The table below provides the average interest rate over 31.5- and 41.5-year time periods ending July 1, 2023 (monthly data from The Federal Reserve Bank of St. Louis).

Reasonable Returns on Bonds and Bank CDs

Today, we consider current interest rates as falling within a normal historical range. There were two periods of abnormal interest rates in the past 50 years: (1) the extraordinary high rates in the late 1970’s to the early 1980’s, when our country was in a vicious wage-price inflation spiral and (2) the extraordinary low rates beginning in the Great Recession (2007-2009) when interest rates near zero or negative lasted more than a decade before the Fed changed direction in the fourth quarter of 2021.

When viewing these two abnormal periods within a longer time frame (centuries), both periods were aberrations and one-off events. So, what does this tell us about our current position and future expectations? Savers and investors are finally able to earn reasonable returns on bonds and bank CDs for the first time in over a decade. We find current rates attractive and, while more upside is possible, we expect to be in the upper end of long-term ranges.

While we contemplate these facts, we remind ourselves of something we have learned through experience━the easy investment decisions most often are not the most strategic and difficult decisions more often work out best. Right now, the great majority of savers and investors are satisfied with receiving 4% to 5% in short-term high-quality debt; it’s easy to save and invest at these rates, which provides competition for stock investments and intermediate term bonds. However, prospective returns are typically much higher for intermediate term bonds relative to short term bills once the Fed has paused its hiking campaign as short-term rates eventually move down.

Over the long-term, future fixed-income returns are highly correlated to the starting yield-to-maturity. For investors today, intermediate term fixed-income returns should be in the mid-single digits.

Common Stocks

For the ten-year period ending August 18, 2023, the S&P 500 Stock Index (SPX) rose from 1,655 to a present level of 4,370, an increase of 164% (10.2% annual average, 12.3% when reinvesting dividends). This ten-year performance includes (data source: Telemet Orion):

• An 11% decline in 2018
• A 34% crash in 2020 when the COVID pandemic became widespread
• The 2022 decline, which exceeded 20% and coincided with bond prices declining sharply as the Fed raised interest rates much faster than economists and investors expected
• From the 2022 market low (October 13, 2022), SPX rose 32% to reach 4,607 (July 27, 2023) and has since declined approximately 5% from the recent peak

With risk-free, short-term rates close to 5%, equities have lost their appeal to some investors.  Yet, for funds that are earmarked for longer objectives and will not be consumed in the next five years or so, common stocks remain attractive with potential returns that will most likely exceed those available from fixed income investments.

The U.S. and global economy have been able to avoid a recession so far, and we believe the current consensus is about right in terms of expected growth and recession probabilities in the near-term. However, over the next year or two, we handicap the odds of a recession as 50/50 with main risks and concerns being political (elections), geopolitical (Russia, China, North Korea, others), continued banking strains, restrictive monetary policy, or an outside shock to the global economy (COVID or other).

For the long-run, stock returns are driven by valuation multiples, earnings growth, and dividends. While it is probable that long-term returns in stocks beat fixed income, returns are also likely to be below stocks’ own historical average due to elevated valuations. If technology continues to unlock growth capacity, it’s possible that returns surprise to the upside.

Investment Outlook and Strategy

We are making subtle portfolio changes in both fixed income and equity holdings. In our bond portfolios, for a portion of fixed-income capital we are adding duration, which means we are locking in current yields with maturity dates extending to seven to ten years (most people would gladly accept the worst return being 5% annually with principal returned in ten years).

For our stock holdings, we remain defensive on asset and equity allocations with a focus on companies that can adapt and grow in the coming years, and with a stock price that we view as undervalued.

Though the world has massive amounts of problems, we expect technological developments to resolve many of them in the years ahead. While media focus is most often nearsighted, we recommend that clients have a more farsighted vision with a time horizon of five or more years. Consider the combination of tools presently available, such as the Internet, smartphones, generative artificial intelligence, virtual reality, and others, such as Apple’s Vision Pro.

Though younger people may find it difficult to imagine life without these technologies, more seasoned adults will recall these technologies were not available, developed, or even conceived of until the late 1980s-1990s. Back in the 1970s, it was difficult or impossible to know or conceive of the noted technologies of today. In a similar manner, we submit that in the next five to ten years there will be several new industries and novel solutions to many problems that seem intractable today.

We surely live in interesting times.