By Ted Reagle

With the Federal Reserve recently raising the target Fed Funds rate to the 5.25% to 5.5% range, now remains a great opportunity—the best in a long time—for retirees to lock in attractive low-risk returns for the portion of their retirement portfolio that they do not want exposed to stock market volatility. 

As we saw last year, even short- and medium-term bond funds were quite volatile and did not provide the countermeasure to stock market declines that investors anticipated. So, locking in guaranteed returns at attractive rates in the fixed income allocation of an IRA or other investment account can be very reassuring for investors, especially after enduring nearly a decade in which returns on CDs and U.S. Treasuries were anemic.

Today, interest rates on CDs, U.S. Treasuries, and money market funds are at their highest level in 22 years. Investors can currently earn in the 5% range on any of these low-risk investments. 

Interestingly, many retirees may not be aware that these rates are available to them because the bank or institution where their IRA accounts are held may not be publicizing or offering competitive rates. These low-risk investment choices can be readily bought in an IRA or taxable brokerage account at firms like Fidelity, Schwab, Vanguard, and many others.

The window to take advantage of these attractive interest rates could likely last for several more months before interest rates start to decline. Investment pundits anticipate that the Fed could increase rates by a quarter percentage point once more before the end of 2023, and that the Fed will begin to reduce rates either by the end of the year or in 2024 as inflation is brought down to the desired 2% range. 

The Fed has raised interest rates for the past 16 months to combat inflation. Higher interest rates tend to reduce demand for goods and services because borrowing costs are higher, which in turn cools inflation. Inflation peaked at 9% in 2022, but fell to 3% in August 2023. 

With the availability of 5% returns on low-risk investments, some retirees may be inclined to significantly reduce—if not completely eliminate—their allocation or exposure to the stock market. This could prove to be sub-optimal, however. Most retirement account investors will want to continue to invest a portion of their portfolio in the stock market to enable their accounts to continue to grow sufficiently and keep pace with inflation during their retirement years. 

Historically, fixed income investments such as the ones we’ve been discussing and longer term bonds  have earned in the 5% range. By contrast, the US stock market has earned in the 10% range, though stocks experience greater market volatility. 

A portfolio comprised of 60% stock and 40% fixed income investments has evolved into a “typically appropriate” allocation for retirement accounts that strike a good balance between the desire to minimize risk with the need for the portfolio to continue growing to sustain income throughout one’s retirement years. For many retirees, investing 100% in fixed income will not provide sufficient long-term returns to support a lengthy life expectancy.

Fitch ratings

I also wanted to touch on the recent news that Fitch Ratings, one of the major bond rating services, has downgraded U.S. government debt, generally perceived to be the safest and most risk-free investment available, from their highest rating of AAA to AA+.  This is the second time in history that U.S. debt investments have been downgraded, the other time being in 2011. 

Fitch cited the federal government’s growing deficit, now at $34 trillion, as one of the main reasons for the downgrade. The rating agency also cited factors including deteriorating confidence in the government’s fiscal management due to partisan divisions and repeated standoffs over the debt limit, higher interest rates, and the failure to address medium-term challenges related to government entitlement programs.

The government deficit continues to increase in 2023, and interest expenses are increasing $180 billion this year as the cost to service government debt has risen with the increase in interest rates.  And Social Security, Medicare, and Medicaid entitlement programs are expected to continue to grow as the US population continues to age. These programs account for two-thirds of all government spending. Finally, tax revenues are down 10% so far in 2023, further exacerbating the deficit.

While the federal deficit is worrisome, the Fitch downgrade should not discourage investors from investing in CDs or Treasuries. The U.S. dollar remains the reserve currency for the world. There is global demand to own Treasuries. The U.S. economy is growing, 2.4% in the most recent quarter. Inflation is coming down. So overall the U.S. economic picture looks pretty good.

By Brant Walker, Chief Investment Strategist

“Now is always the hardest time to invest, especially when the market is exhibiting schizophrenic behavior.” 

This statement could apply to virtually any period in the last three-and-a-half years, starting with the impact of the COVID-19 pandemic and its associated disruptions. Before we take a look at the first half of 2023, it will be useful to review the market trends that have characterized this uncertain period and what they mean for current and forward-looking investing climates.

How we got here

The year 2020 started on a high note, with the S&P 500 index closing 2019 with a stellar total return of 28.9%. Then the potential gravity of the coronavirus became clear in February 2020. In five short weeks, the S&P lost 33 percent of its value, bottoming out on March 16th.

Around that time, the federal government began rapidly printing money to buttress businesses that had to shut down and employees that were ordered to stay home, many of whom lost their jobs. This infusion of cash buoyed the market, and stocks finished the year up 16.3%. 

The year 2021 was also an excellent time for stocks due to continued money creation and the wide distribution of COVID-19 vaccines, which helped restore a sense of normalcy and optimism. The S&P 500 index again finished strong, with a 27% gain for the year.

The following year, reality set in. The elevated money creation of the previous two years led to excess demand, driving inflation to a 40 year high of over 9%. The Federal Reserve reacted, perhaps belatedly, by raising interest rates from zero to where they stand today, at just over 5%. The stock market acted as it often does in a period of sharply rising rates and dropped, tumbling 19.5%. 

2023 so far

After a brief but steep stock market loss in early 2020, followed by two years of strong returns, and another significant downturn in 2022, where are we today after the first two quarters of 2023? To date, the market has done another about face by returning close to 15 percent. Schizophrenic indeed.

We are dealing with an unusual combination of data points that will need to be carefully monitored and addressed as 2023 unfolds. First, the yield curve has been inverted for well over a year, meaning short-term interest rates (think money market funds and bank CDs) are higher than longer term interest rates. In normal times it would be the other way around. 

Money funds now pay close to 5% and some short-term CD’s can be had for 5.5%. Long maturity U.S. Treasury bonds are yielding under 4%. This is due to the Federal Reserve trying to slow the economy and raise unemployment to get inflation back down to the 2% range. 

Despite this effort, the economy remains resilient. The national unemployment rate is near a 40-year low, and inflation remains stubbornly above 2%. Fiscal policy in Washington is also hampering the Federal Reserve’s intention of lowering inflation, as government spending and new social programs continue to pour money into the system. 

It may take more time than anticipated to get inflation down to target, and this is a risk to the markets — both stock and fixed income. Hence, we are approaching the second half of 2023 in a cautious stance.

The impact of AI

We also feel it is worthwhile to spend a few moments on artificial intelligence (AI). Some say the growing capabilities of AI have the potential to change the world, similar to the invention of electricity and the automobile. Time will tell, but we do know that a handful of technology stocks that are on the forefront of AI have appreciated rapidly due to current hype and their possible future potential. 

The situation is similar to market behavior in 1999, when the internet was still in its infancy. Anything labeled internet, and any company that had .com attached to its name, soared in value. There’s a reason this trend was referred to as the “dot com bubble,” though. In March of 2000, the highly touted tech stocks came back to earth. Some took years or decades to recover to their 1999 highs. Some have never recovered.

The bubble also allowed a handful of companies to dominate the tech sector and drive the majority of market returns. A similar trend is happening today, with six stocks accounting for most of the year-to-date market return in the S&P 500. We don’t know exactly how the AI cycle will play itself out. History doesn’t always repeat,but it often rhymes.

Year-over-year market changes

The benchmark S&P 500 stock index has returned 19.6% for the year ending June 30, 2023. The benchmark iShares Core US Aggregate bond index ended the same period in negative territory, logging a -3.5% return. These returns are in stark contrast to calendar year 2022, when the S&P 500 logged a negative total return of 18.1% and the iShares Aggregate bond index lost 14.6%. 

Usually, one would expect bonds to act as a buffer when stocks fell as much as they did in 2022. In calendar year 2022, both stock and bond markets began, in retrospect, at levels that would prove to be highs for the year. Both markets plummeted in sawtooth fashion before reaching their lows on or around November 1. 

This was caused by the Federal Reserve lifting short-term interest rates from essentially zero to the 5% level that is prevailing today.  Early in 2022 most market participants expected interest rates to stay near zero or increase on a much slower trajectory than what has actually happened, causing stocks and bonds to plummet. 

Stocks have staged a strong recovery since last November as the market has become more comfortable with interest rates at 5% and the economy remains resilient. In addition, the labor market remains strong, and the unemployment rate sits near historic lows.

Economists have been predicting an economic recession for the better part of a year based on the “inverted” yield curve, where short-term interest rates are higher than long-term rates. Inverted yield curves often presage economic recessions as the Fed attempts to slow economic activity and cool inflation. Some market pundits have quipped that this is the most widely predicted recession that never happened, at least up until now.

Year-end forecast and expectations

Market performance in the back half of 2023 depends on several variables which are yet to unfold. The first and most prominent factor will be how far the Fed increases its interest rates before the economy and inflation cool to acceptable levels. Recent reports show the economy remains resilient, inflation is still too high, and job creation has been surprisingly strong. 

Elevated government spending based on recent bills passed in Washington is complicating the Fed’s action to slow the economy. Common stocks are highly valued based on historical standards, particularly with short-term interest rates above 5% and potentially headed for 6%. 

We may have to “thread the needle” in the back half of 2023 for the markets to remain resilient. Meaning inflation, the economy, and the labor market will need to cool without triggering a deep recession. We suspect the second half of 2023 may be more challenging than the first half.