Serious Headwinds: 3rd Quarter 2022 Commentary

Serious Headwinds

Six years ago I wrote in these pages about my preparations for a 75-mile backpacking trek with my two older sons at Philmont Scout Ranch. Philmont is the Boy Scouts of America’s largest national High Adventure Base and the world’s largest youth camp. The ranch covers 140,000 acres—about 220 square miles—of rugged mountain wilderness in the Sangre de Cristo range of the Rocky Mountains in northern New Mexico. Philmont offers 315 miles of trails over rough terrain, and elevations that range from 6,500 to 12,440 feet. More than a million Scouts and their volunteer leaders have traveled to Philmont since Oklahoma oil man Waite Phillips gave the ranch to the Boy Scouts in 1938. Each summer, approximately 22,000 Scouts and leaders will hit the trail for a ten-day backpacking expedition. Each day, 350 arrive, 350 leave and 3,500 will sleep in the backcountry.

I’m happy to report that our 2016 Philmont trek was the trip of a lifetime. Physically hard, yes. Mentally challenging, of course. But worth it! It was a wonderful experience to share with my boys. But even as I huffed and puffed over mountains and hunkered down during electrical storms, I couldn’t help but think of the fact that I had a third son back home who would be old enough to take his own trek six years later in 2022! Would I still have the chops for that at age 54? Could I trudge 75 miles with a 45-pound pack, eat meal after meal from plastic wrappers and, most daunting, handle ten nights sleeping on the ground?

Well, as you probably guessed, my second Philmont trek is now “in the books” and this old man did just fine! My son Charlie (14) and I had a wonderful trip and yes, it rivaled my earlier trip. Version 2022 was more challenging than version 2016, not because I am old, but rather due to the weather! We went in the second half of July, also know as “monsoon season” at Philmont. Without fail, the thunderstorms rolled in every afternoon and we found ourselves wet and chilly as we set up camp for the night. Sleeping in a tiny tent is one thing when you are tired, and quite another when you are tired, wet and cold! Fortunately, most mornings brought sunshine and warm weather to dry us out for the day ahead.

That was the case on our most memorable day of the trip, our ascent of Baldy Mountain, the highest peak on the ranch at 12,441 feet. We got up in the dark and hit the trail early to avoid being on the summit when the afternoon electrical storms rolled in. It was sunny and warm as we made our way up the shoulder of the mountain. At about 10,500 feet of elevation, we emerged from the trees and could see the entire mountain before us; the summit and shoulders of Baldy are alpine (no trees). Hence, the name! The views were spectacular in all directions, but we couldn’t help but notice the wind picking up. The higher we climbed the harder the wind blew and it was driving right in our faces; it made for a serious headwind, as if some mountainous force didn’t want us to make it to the summit.

But make it, we did! And gosh was it windy on top! None of us had experienced wind so strong. It howled! We couldn’t hear one another’s voices, even when shouting. Loose hats and gloves sailed away like birds on the wing. We struggled to stand upright as the powerful gusts raked the mountaintop. The 360-degree view was fantastic but for the most part our attention was strictly focused on the wind. For 20 minutes or so we staggered around on the summit snapping photos and then, seeking calmer conditions, we hightailed it off the side. As we made our descent, we decided that it must have been blowing at more than 50 miles per hour and we unanimously concluded that never had the wind blown so hard on Baldy Mountain.

Speaking of headwinds, higher interest rates have been a serious headwind for stock and bond prices this year. As shown in the table of index returns above, prices for large caps (S&P 500) are down more than 20% year-to-date through 9/30/2022 while small caps and foreign stocks are down even more. While the stock returns look quite bad, the results are not surprising given extremely challenging economic conditions. Bond returns, on the other hand, are shockingly bad. The Bloomberg Barclays Aggregate Bond Index is down 14.6% this year, by far the worst return for this index at this point in the year since inception of the index in 1976. The chart below shows full-year returns for this index (in black) and it also shows intra-year declines (in red) for each year. 2022 is an obvious standout.

Going back even further, the Federal Reserve Bank of St. Louis maintains a database of annual returns for various indices back to 1928 including ten-year Treasuries and investment-grade (high-quality) corporate bonds. The year-to-date 2022 return for ten-year Treasuries is worse than any annual return for ten-year Treasuries for the entire 93-year period. The same is true for corporate bonds. Comparing a nine-month return to full-year returns is not a perfect comparison but we don’t have perfect data and the exercise makes clear that this is a very unusual year.

Why so bad? First, it is no secret that the Fed has been aggressively raising interest rates to tamp down inflation, as Matt Devries explains in his Q3 2022 Market & Economy commentary. Interest rates and bond prices are negatively correlated—when rates rise, bond prices fall and when rates fall, bond prices rise. But the Fed has raised rates before now—there have been many such cycles over past decades—and bond returns never fared as poorly. Unique to today’s environment is the fact that the Fed began aggressively raising rates in large increments at a time when rates were near record lows and bond prices were near record highs. In August of 2020, the yield on a ten-year Treasury bond closed at a low of 0.52% as the Fed implemented extremely low rates to prop up the economy in the face of the global pandemic. To push rates down, the Fed bought bonds, huge quantities of bonds. You can read about this phenomenon in It’s the Fed (Q2 2020). This massive buying spree pushed bond prices up and yields down, in both cases to record levels.

In prior tightening scenarios, the Fed likewise pushed short-term rates up to slow the economy but from a much higher starting yield. For example, during 1999–2000, the Fed raised rates six times, moving the Fed Funds target from 4.75% to 6.50%, an increase of 1.75 percentage points, leaving rates 35% higher than when the tightening began. In contrast, when the Fed began tightening in March of this year, the Fed Funds target was 0.25%. The Fed’s recently published projection calls for the Fed Funds rate to reach as high as 4.5% by 2024. This is an increase of 4.25 percentage points, a seventeen-fold increase in short-term rates! Said another way, the cost to borrow has gone from an all-time low to moderately high in just seven months. This higher cost of borrowing has lowered the price of all risk assets including stocks, bonds and real estate. Any security—with current value based on future cash flows such as rents, bond coupons, or dividends—is worth less today than before rates rose. In a closer-to-home example, in the last twelve months, the average rate on a 30-year mortgage has gone from 3.1% to 6.7%, an increase of more than 100%. The annual interest cost for a prospective home buyer has doubled, resulting in far less purchasing power and a corresponding drop in home prices.

Shouldn’t the Fed have seen the inflation problem coming and raised rates sooner? Shouldn’t we have seen this coming and dumped our bonds? With hindsight, it appears obvious. But back when the ten-year Treasury yield was at 0.52% and the economy was shut down, the fear was that rates would go even lower. After all, government bonds issued by Japan and many EU block countries had negative yields and the fear was that US bond yields would soon follow. The Fed advised that inflation was transitory, resulting from a temporary spike in demand coinciding with a COVID-induced supply problem. This pig-in-a-python analogy sounded logical but it proved to be wrong. The supply and demand imbalance has lasted much longer than expected—it’s either an enormous pig, a very long python, or both! Supply constraints are only now showing widespread signs of easing and consumer demand, while shifting from demand for goods (cars, homes, furniture) to demand for services (travel, dining, entertainment), has remained strong despite the Fed’s best efforts to slow it.

And speaking of things looking obvious with the benefit of hindsight, we have always liked the chart above which shows the path of interest rates over the last 60 years. With this chart in hand, it’s obvious what we should have done and when we should have done it. In particular, note that a ten-year Treasury hit an all-time high yield of 15.8% in September of 1981; we obviously would have been wise to load up our portfolios with long-dated bonds at that point and just sit on them for the next few decades. But let’s drill in even further. Note the volatile path of rates from 1981 through 2022. Yes, rates declined dramatically over that 40-year period, but all along the way they went down and then up and then down and then up and so on. An even more enriching strategy than buy and hold would have been to buy and sell at opportune times. Just think of the money we could have made!

Today, everyone has something to say about inflation, bond yields, the Fed, and yes, what will happen in the future. “Rates will go higher!” “Rates will go lower!” “Inflation is here to stay!” “Inflation will subside!” “The Fed failed us!” “The Fed is on the job.” “It’s different this time!” “We’ve been here before,” etc. Now go back to that long-term chart of interest rates and consider that at every single turning point for bond yields, the conversation was the same. Imagine the cacophony of voices. At market bottoms and at market tops, emotions run high, forecasts become extreme and we humans are sitting ducks for the media where, “If it bleeds, it leads.” When voices get shrill it is important to remain disciplined.

Finally, look at that chart one more time. Put your finger on 9/30/2022. At quarter-end, the ten-year Treasury yielded 3.8%. Two days prior, the yield briefly surpassed 4%, and as I type on October 4th, the yield is down to 3.6%. Ask yourself where it is going next.

I’ll be the first to tell you that I don’t know where it’s going next. And I’ll suggest that you don’t know either. Nor does Fed Chair Jay Powell, Warren Buffet or anyone else. But we all have an opinion, and everyone’s opinion is right there in today’s price. Today’s price reflects the opinions of thousands and thousands of investors, some brilliant, some not so brilliant. Each trading day, more than $500 billion in Treasuries change hands. That’s a lot of money! Informed buyers and sellers are betting (investing) real money … huge amounts of money. Each day they are agreeing on a price and trading. So, when you hear the expert who is “famous for predicting the last big crash,” telling us that rates are going higher/lower, remind yourself that talk is cheap. Remind yourself that billions of dollars changed hands at today’s price. Who do you trust? That “expert” helping to garner eyeballs for the network, or the investors trading billions at a mutually agreed upon price? At Bragg, one of the tenets of our investment philosophy is humility. I’ve always thought it to be the most important component in our success. We are humbled by the market. We are humbled by this simple chart. We will never make big bets in the portfolio such as trying to time the market, rotating among sectors, loading up on our “best ideas” or chasing what has been hot.

As for the Fed and its future moves in setting short-term interest rates, the chart below includes the projections of the Federal Open Market Committee as well as the implied projections of investors, based on billions of dollars in trades. It is important to note that the Fed and market investors could be wrong—indeed, they could be way off the mark. But if there is a consensus guess for the path of short-term rates in the future, this is it.

What now? Our portfolios are down. Should we make changes? What should we expect going forward? Look at the two-part illustration shown below. It is busy, but we think it can help you get comfortable with the bond portion of the portfolio. We have always described bonds as the more stable part of the portfolio and the long-term history of bonds demonstrates why that is the case. Again, this year is a standout. But bonds are different from stocks, and this year’s volatility notwithstanding, bonds remain the more stable part of the portfolio. If there is any positive aspect to the beating bonds have taken this year, it is that yields are now significantly higher than during the past two to three years. As we have just discussed, yields may remain at these levels, they may go higher or they may go lower. It is our hope that most of the damage in the bond market has been done. Importantly, we feel better about the return potential our bond portfolio offers than we did during the many years when bond yields were closer to 1%. Depending on your need for stability and liquidity in the portfolio as captured by your written investment plan, Bragg will continue to own a diversified bond portfolio.

Tired of talking bonds? As mentioned, stocks have also taken a beating. The chart below shows the resulting silver lining. Stock valuations today are far more attractive than they were at the beginning of this year when the market was at an all-time high. This doesn’t mean we are home free. The market could certainly worsen and we should tell ourselves that it will.

Sir John Templeton is most famous for saying that, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” I think you will agree that this is a brilliant description. Think back to the Crypto/Peloton/GameStop/SPAC days of 2021. Those were euphoric days! We are a long way from there, aren’t we? Today, pessimism abounds, sentiment is bearish, consumer confidence is low and economic indicators are weak. Much of this is warranted as there are serious challenges facing the economy and the market. Conditions may worsen yet but don’t lose sight of the fact that the market is forward-looking. It will turn up long before the good news arrives.

The wind will always blow. We think it makes sense to stay on the trail. Thank you for trusting Bragg with your planning and investing.

Benton and Charlie Bragg face the headwinds atop Baldy Mountain

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.