November 9, 2023 Letter to Clients
We hope this letter finds you in good health and high spirits as we approach the end of 2023 and enter into the joy of the holiday season.
Navigating the intricacies of investing often means wading through a sea of news and tv headlines. Our objective is to unravel these recent developments, shedding light on key factors essential for providing clarity that empowers informed financial decision-making, and enhancing a deep understanding and a collective awareness of what is at play in our world.
In this letter, our discussion will encompass the economic ramifications of the Israel-Gaza conflict, the looming prospect of a U.S. government shutdown, and the changing dynamics of Treasury yields. As stakeholders in the financial realm, we believe it is imperative to navigate these complexities with a balance of gravity and professionalism, and in doing so, will bring some outlook for year end.
The Israel and Gaza Conflict: Economic Repercussions
One of the challenging aspects of investing (and writing about it) is that financial markets tend to remain detached from human tragedy. Despite the devastating loss of life and the horrifying events that have unfolded, markets primarily focus on economic factors, be it natural disasters or conflicts. Israel’s declaration of war in response to the bombardment by the Gaza-based group, Hamas, is no exception. While human suffering is undeniable, markets tend to be driven by the economic considerations.
The Israel-Gaza conflict carries potential consequences that extend beyond the immediate human tragedy. While the direct economic impact on Israel and Gaza is significant, the conflict’s broader regional repercussions remain uncertain. Israel is a prominent trading partner with many Western countries and is a major natural gas exporter to Egypt and Europe. If the conflict continues to escalate, disruptions in trade and energy supplies could lead to increased volatility in global markets. Furthermore, the involvement of key oil-producing nations in the region, such as Iran and Saudi Arabia, raise concerns about potential oil price spikes, given that these countries collectively account for a substantial portion of the world’s oil production. While the regional repercussions of this conflict are still uncertain, as events are ongoing, and it’s unclear how far-reaching the war will be, the conflict underscores the delicate balance between geopolitical instability and its potential ramifications for global economic stability.
Government Shutdown: Looking Past Political Noise & Staying the Course
A U.S. federal government shutdown was avoided ahead of the September 30th deadline with Congress successfully passing a temporary funding bill, ensuring the government’s continuous operation until mid-November. However, the fundamental issue persists. While the government remains operational until November 17th, Congress must reach an agreement on a budget for the current fiscal year, which commenced on October 1st. Or, they must implement another stopgap measure by the mid-November deadline. Failure on both fronts would result in the government’s fourth shutdown in the past decade.
Historically, government shutdowns, if they occur, have had a modest impact on both the economy and stock markets. Nonetheless, the potential for a shutdown this time could be more disruptive. The economy is currently contending with macroeconomic challenges, such as elevated oil prices, an automobile industry strike, and the resumption of student loan repayments. Additionally, investor confidence has been dampened by rising bond yields and the Federal Reserves’ indication of a slower pace for anticipated interest rate reductions in its recent economic projections.
In general, these shutdowns tend to be less disruptive than investors anticipate because they are typically short lived and critical functions like social security and healthcare services continue to operate. These shutdowns do not affect state and local functions. Unlike the debt ceiling issue earlier this year, this time we are not facing the risk of the Treasury Department defaulting on its obligations. When we look at history, the research suggests that stocks are not significantly impacted with the S&P 500 showing little overall change. Important to note in the aftermath of a shutdown, the S&P 500 has, on average, gained 1.2% after one month and 2.6% after three months.
In the unlikely event of a prolonged shutdown, increased market volatility could be introduced. In addition to a delay of critical data the Federal Reserve relies on to make interest rate decisions, the U.S. could lose its AAA Moody credit rating. This, combined with other factors such as geopolitical uncertainty, oil prices, labor strikes etc… could further investor uncertainty.
We continue to closely monitor developments in Washington and our stance is that investors should look past the political turbulence and remain on track. The short-lived shutdown is not viewed as a substantial threat to either the economy or markets, and any impact would be temporary.
Treasury Yields
As an investor, you hear the term “Treasury yield” quite a bit, and if you are tuned into the financial news, you are hearing it discussed more frequently with yields having risen to levels not seen since 2007, the earliest days of the financial crisis.
Treasurys, as they are commonly referred to, are fixed-income securities issued by the federal government to fund its operations. They are debt instruments in which investors are lending the U.S. government money, and in return, are paid interest on that loan. Treasurys come in varying maturity lengths and can be an important part of a diversified investment strategy. The yield determines the value the Treasury holds in a portfolio given it represents how much profit an investor can earn with their purchase. As the prices of bonds rise, the yield goes down and vice versa. Explained another way, bonds and interest rates have an inverse relationship: bonds tend to lose value when interest rates rise. This is known as interest rate risk. The risk of buying a Treasury bond of longer duration is that interest rates will likely increase during the bond’s life. Thus, your bond will be worth less on the market than new bonds being issued. This is why longer duration Treasurys tend to pay higher interest than those of shorter term to compensate investors for the interest rate risk they assume with the purchase.
The 10-year Treasury is the most closely watched government bond as it is used as a baseline against which the risk of other investments is assessed. It is also used as a benchmark for banks to calculate mortgage, auto loan and student loan rates as well as other debt. During periods of market uncertainty, the demand for the 10-year can increase significantly given it is traditionally viewed as a safe haven instrument to reduce volatility in an investment portfolio. With its popularity among retail investors, central banks and governments, there is steady demand for the 10-year note and thus it carries ample liquidity. A rise in the 10-year Treasury yield means the U.S. government must pay more interest to borrow money for 10 years as investors are demanding a higher return to lend their money. As mentioned earlier, Treasurys, given they are backed by the U.S. government, are typically viewed as a low-risk investment, however this demand for a higher return may in part be the result of investors’ concern about rising U.S. government debt and lack of stability, leading to a perceived greater risk of our government’s inability to pay back debt in the future. Yields also tend to rise and fall according to the Federal Reserve’s interest rate policy and investors’ interest rate expectations. With the central bank having aggressively hiked the benchmark rate since early 2022, bond yields have been pushed higher.
While this rise in yields is unwelcome news for those wishing to borrow money now or in the immediate future, those who are investing and saving can benefit from these high yields, while they last.
Interest Rate Outlook and Impact on Treasurys
Earlier this month, the Federal Reserve (the Fed) once more opted to keep benchmark interest rates unchanged, maintaining stability in light of a flourishing economy, a surprisingly resilient labor market, and inflation levels that continue to exceed the central bank’s target. As anticipated, the Fed’s rate-setting committee unanimously decided to retain the key federal funds rate within the 5.25% to 5.5% target range. It remains to be seen if one last rate hike will occur in the December meeting or if rates will remain as-is to end the year.
Looking ahead to 2024, it is currently anticipated by both policymakers and the markets that by the conclusion of 2024, the Fed funds rate will experience a modest decline, albeit more prominently in the latter part of the year. Nevertheless, the anticipated decrease is expected to be mild when compared to the pace of the increases recently experienced with projections placing the fed funds rate in the range of 4% to 5%.
When the Fed funds rate decreases, it typically leads to a decline in short-term interest rates across the financial markets. As a result, the yields on Treasurys, especially the shorter-term duration, may also decrease given they’re less attractive compared to investments with potentially higher returns, which then impacts demand. Conversely, existing Treasury bond prices may rise as their overall yields become more appealing in a lower rate environment.
The Case for Staying Invested & Rethinking the Dash to Cash
Recent weeks have presented a financial multitude of challenges, including the uncertainty surrounding third-quarter earnings season, surging Treasury yields, political gridlock in Washington, and the devastating suffering and loss of life as the conflict in the Middle East unfolds. When market uncertainty begins to unnerve investors, it is natural to consider moving to the sidelines with the hope of re-entering the market once things begin to “look better” or “calm down”. However, historical data suggests this may not be a wise decision.
According to Bloomberg, since 1990, missing the best-performing month each year in the S&P 500 would result in a 7% lower return compared to remaining fully invested. This gap widens to over 12% if an investor were to miss the top two months each year. For fixed income, failing to capitalize on the best month annually would lead to a 3% lower annualized total return, and that figure rises to over 5% for missing the top two months each year. When trying to time the market, an investor must be correct twice – first when exiting the market and then when re-entering it. Unfortunately, that is an exceedingly challenging feat even for the most seasoned investor. For many investors, moving to the sidelines often results in missed opportunities and substantial underperformance in the long run. Amid the uncertainty, we encourage clients to remain invested, as the best performing days often quickly follow the worst – a trend we have seen play out over many market cycles.
Since the start of 2022, more than $5.6 trillion has poured into U.S. money markets assets, which is $1 trillion more than last year. Even though cash seems attractive because it can provide higher returns in a higher-rate environment, it is important to be cautious. While we will always recommend our clients maintain a solid cash balance in the bank, having too much in cash might make it hard to reach long-term goals when compared to a diversified multi-asset approach. As we may be approaching the conclusion of the Fed’s hiking cycle, the potential risks of overcommitting to cash become more pronounced given that historical trends suggest money market funds may underperform various asset classes. Additionally, with the possibility of rate cuts in 2024, investors who were previously invested and who made a substantial shift to cash will face reinvestment risk – defined as the possibility an investor may receive lower returns or yields during a period of declining interest rates when they need to reinvest cash proceeds from previously held investments. The key takeaway here is that cash returns are unpredictable therefore we advise a careful approach to your cash allocation and the need to consider a multi-asset approach for long-term investment goals.
As we approach the conclusion of another year, we would like to acknowledge that your trust in LePage Financial Group is deeply appreciated, and we look forward to continuing this journey with you. In the world of finance, each year brings new challenges and opportunities as life evolves and we are honored you have chosen our firm to navigate them together. As always, we welcome you to contact our office should you wish to discuss your financial plan, review your portfolio and to keep us informed of what plans you may be planning for in the new year and beyond. We extend our sincere gratitude for your partnership, wish you a joyous holiday season, and anticipate the opportunities the coming year may bring.
Best Wishes,
Steven LePage