The second quarter proved to be every bit as challenging for investors as the first quarter this year. 2022 seems to be the year when the consequences of a lot of poor policy decisions have come home to roost. Inflation and rising interest rates are the two main issues that the markets are wrestling with, largely driven by an unprecedented expansion of the money supply, soaring energy costs and persistent supply bottlenecks.
Not surprisingly, the stock market has responded to this uncertainty by selling off roughly 20% year to date. A third of the S&P 500 sectors are off even more. The two worst performing sectors are consumer services and discretionary. Both are down about 30% year-to-date. Bond prices have also been hit hard as interest rates have nearly doubled from a year ago. Bond indices that track medium and longer dated maturities have been declining since last year and are now down between 11 and 16 percent. So there really hasn’t been anywhere to hide except for cash and very short-term bonds.
A 20% decline in stocks is far from unusual and while unpleasant, is a normal sell-off that we’ve seen countless times before. These “corrections” seem to come around every five or seven years and have little impact on the long-term investor’s success in achieving their goals. It’s a very different story for retirees, though.
Retirees are income investors and this is where an important distinction should be made from younger people trying to build wealth for retirement. Presumably, a retired investor has built their wealth over their working career and are now in a position where they want to enjoy the wealth that they have created. This enjoyment comes from the cash flow that their portfolio can generate and the cash flow is directly tied to interest rates or yield.
The most significant challenge to retirees, really since the financial crisis, has been the ability to generate cash flow. In response to that crisis, the Federal Reserve began an extended campaign to lower interest rates in an effort to bail out borrowers and support the housing market. They did this with something they call Quantitative Easing or QE. The first three rounds of QE lasted only a few years but the effects of it were felt for many more after that. Ever since then, bond yields have remained stubbornly low. This meant that your savings didn’t go nearly as far in generating income as it used to. This meant you had to retire with far more in savings to make the same cash flow. In many cases, it meant you had to retire with twice the savings. That’s asking a lot of someone.
As time went on, the government realized they needed to unwind these programs and allow rates to rise. This was a tall task however because it meant shrinking the money supply trillions of dollars without creating a recession. The near total economic shutdown of COVID in the summer of 2020 changed everything. One of the policy reponses to keep the economy afloat was another round of QE. This time, it was massive. QE number 4 was as large as QE 1-3 combined. As a result, interest rates collapsed. The yield on the ten-year treasury dropped from nearly 3% to 1.5%. Yields on all bonds fell in a similar fashion. Once again, income investors got hammered. No one seemed to care however because the stimulus that was pumped into the economy sent stocks to record highs leaving investors feeling wealthier. The truth was that the gains in the stock market weren’t enough to make up for the loss in yield. Comparing these two things is tricky because declining income isn’t as obvious as seeing the change in an account balance.
That takes us to today. A big part of this selloff is driven by higher rates. In fact, rates have doubled to pre-pandemic levels which are still low by historical standards but livable for most income investors. So, the question one has to ask is what’s more important to a retiree – wealth or income. We think the trade -off thus far is a good one. The higher income available now is worth lower stock prices because the impact on income is more durable while stock prices tend to recover in a shorter time frame. For growth investors, this market is just another bump in the road.