Ep 55: How Bonds Work: What Retirees Need To Know

On This Episode

Too many folks misunderstand bonds, how they work, and what role they play in a proper financial plan. We’ll address some of those bond related issues on today’s show.

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PFG Private Wealth Management, LLC is an SEC Registered Investment Advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. The topics and information discussed during this podcast are not intended to provide tax or legal advice. Investments involve risk, and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed on this podcast. Past performance is not indicative of future performance. Insurance products and services are offered and sold through individually licensed and appointed insurance agents.

Here is a transcript of today’s episode:

 

Marc Killian: Welcome into another edition of the podcast, Retirement Planning – Redefined with John and Nick from PFG Private Wealth. And it’s time to talk about bonds and really what you need to know and how they actually work. And there’s a lot of conversation around that, obviously in ’22, certainly to the fact that nothing seems like a good idea as far as things go. And when the market is weird, often we run to bonds for the safety aspect, but there’s some things going on there too. So, let’s talk about how they actually work, what role they might play in a proper financial structure and how maybe this here lately, it’s been a bit of a different show in that regard. So guys, welcome in. Nick, what’s going on buddy? How are you?

 

Nick McDevitt: Pretty good, pretty good. Staying busy.

 

Marc Killian: Yeah, that’s good. Very good. John, and you? How are you doing?

 

John Teixiera: Doing all right.

 

Marc Killian: Yeah?

 

John Teixiera: Hanging in there.

 

Marc Killian: How’s the bond market? A little rough.

 

John Teixiera: Little rough if you’ve owned some already. Could be good if you’re buying some new ones.

 

Marc Killian: Yeah, right. And that’s the difference, right?

 

John Teixiera: It depends where you’re at.

 

Marc Killian: Depends where you’re at. So yeah, we’re going to talk about that a little bit. First thing I want people to understand is that the bond market is actually way bigger than the stock market. A lot of people don’t know that. That’s just an interesting little tidbit, but it is a lot bigger.

 

John Teixiera: Yeah. Yeah, a lot of people aren’t aware of that, but-

 

Marc Killian: There’s a whole lot more stuff in there. Right?

 

John Teixiera: Yeah.

 

Marc Killian: But let’s go into the misunderstandings, right? So first off, just why don’t you guys give us the basic gist of how a bond works, for folks who just might not know?

 

John Teixiera: Yeah. So, to break it down to its simplest form, a bond is basically loaning your money to a public institution or private entity. So, you’re basically saying, “Hey, I’m going to give you my money.” And for that, the company typically provides some type of interest rate for that period of time where they have your money. And as far as obligations go from that company or public institution, there’s a promise to pay you back. And that promise is only as good as the paying ability of that company. So, I think that’s bonds in a nutshell, if you try to break it down to its simplest form.

 

Marc Killian: Yeah, you’re loaning the company money, right? You’re lending them money versus as a stockholder you’re buying a piece.

 

John Teixiera: Correct.

 

Marc Killian: Yeah. Okay. Nick, what’s the difference between a bond and a bond fund? So, like an individual bond and a bond fund? Because most of us wind up with bond funds and we’re maybe not totally sure what it is we have, we just say, “Oh, I have some bonds.” But what they really have is a bond fund.

 

Nick McDevitt: Yeah. The reality is the difference as far as how it affects a typical investor is the important part to understand. So, with bond prices and interest rates having an inverse relationship, so again, if interest rates go up, bond prices go down, then the issue that somebody that has invested in a bond fund has is it’s a pool of bonds. And so, you’re relying upon the manager of that bond fund to manage the buying and selling of those bonds while trying to protect the value of your account and gaining interest. So, sometimes the easiest way to guide people through this, and obviously we’ve been having this conversation quite a bit lately with people, especially with how we’ve invested in fixed income in the last few years, is that if you own an individual bond, you have the ability to hold it until maturity. And when you hold it until maturity, you then receive the par value back. And this might be a little bit too much detail, but we’ll try to give people a good understanding of this. So, oftentimes people get confused with the difference between the initial issue of a bond and then when it trades in the secondary market. So, when a company initially issues the bond, that’s when they are receiving the loan basically, or the money from whoever purchases that bond initially. So, when they sell the bond, the bond sells for $1,000, there’s a promise to pay that the company issues with the bond as well as, “Hey, in the meantime we’re going to pay you an interest or a coupon.” So, let’s just say it’s 3%. So, company A, we’ll call them Apple, Apple issues a bond in 2020 for five years and they’re going to pay 2% over those five years. And as long as whoever holds that bond at the end of that five years, no matter what they paid for it, they’re going to get $1,000 back. That’s the promise.

 

Marc Killian: Okay.

 

Nick McDevitt: So, we’ll say John bought that bond initially, but two years into it he decides, “Hey, I no longer want this bond, I’m going to go ahead and sell it.” So, because of the market situation and what’s going on in the market, that bond in the secondary market, because interest rates have gone up, even though he paid 1,000, he can only sell it for 900, because that 2% coupon rate isn’t competitive.

 

Marc Killian: Right. Yeah.

 

Nick McDevitt: So, let’s say he sold it to me and I bought it for 900. So, I got a discount like, “Hey, I’m only getting 2% so I’m not going to pay less, so I’m going to get a discount.” And now my goal is I’m going to hold that bond until the end of that total five year period and I’m going to collect that 2%, but I’m also going to get the extra $100 on top, which makes my return, my overall return, my total return higher. So, the difference is that when people, as an individual, when they own those bonds individually, they have more control over holding that into maturity and essentially getting their par value back while collecting their interests in the meantime versus when it’s in a bond fund, that performance is strictly going to take place dependent upon how it gets managed. And we know obviously it’s confusing and it’s always a tricky spot of trying to help people understand and giving what might be too much information. But with this, I think a lot of times it’s the more you know, the better it is to try to understand it.

 

Marc Killian: Yeah. And we’re going to talk a little bit more about some normal things that we’re used to thinking about or hearing and how it messes us up a little bit. And John mentioned earlier, he is like, “Yeah, if you’re getting into a bond right now, higher interest rates, they look a little bit more appealing than someone who bought maybe a year ago, as the rates were down lower.” And to your point, you said the inverse reaction. I was always taught, an easy way to remember it is when rates are high, bonds die. So, little rhyme, helps you remember it. So, when rates are high, bonds die, because the value. Right? So, they have that inverse reaction. That’s just a good way to think about it. So, John, a lot of people consider them to be the safer, conservative part. I want to jump to the standard 60/40 for just lack of a better term. Right? We’ve grown up with this thing of when the market’s rough go to bonds, right? As you get older, go to bonds, because it’s a safer option and we feel as though it’s that safe, conservative part of the portfolio. Do you agree with that approach normally? And what’s your take on it this year when it’s also having a lot of trouble?

 

John Teixiera: Yeah, normally I’d say that you’re correct. Yeah, normally that is how it works. This year it’s a little different obviously with the Federal Reserve really trying to hedge against inflation. So, they have been aggressively raising the rates. So, that’s where you’re starting to see these bond values drop drastically. And I don’t know the exact number, but I think year-to-date we’re almost negative 10 to 15% in the [inaudible 00:07:35] bond index.

 

Marc Killian: Yeah. It was close to 15, last I checked.

 

John Teixiera: Yeah. That’s actually what’s happening in people’s portfolios where if the market was down, they have at least a bond portion that’s level or maybe down a little bit or up a little bit. But right now it’s like, hey, you’re getting two sides of it where they’re both getting hammered. This is where it’s important, and Nick mentioned, how can you mitigate that risk? And you can do it, it’s just a matter of structuring the portfolio and getting the right type of investments to understand, “Hey, in this type of environment, this is where I want to be.” So, it really comes down to, again, this is your investment plan. Like, “Hey, what’s your investment plan to mitigate this type of environment and how do you take some of this risk out of your portfolio?”

 

Marc Killian: Yeah. Nick, back to you, and the question I asked you a minute ago, people say, “Well, individual bonds themselves may not still be a bad option right now in this current bond environment, but it’s the bond funds that tend to be taking a bit more of an issue.” And to your point, you mentioned, actually maybe it was John who mentioned them being a pooled investment, but either way, right? And that bond fund manager, whereas an individual bond may still be an okay option. So, that’s really where you need to talk with your advisor or have an advisor to find out if you’re thinking about bonds, what’s the right avenue to go? Am I on track there or is that incorrect?

 

Nick McDevitt: Yeah. To a certain extent, for sure. And another thing that happens, one of the things that we’ve integrated into clients’ portfolios, and we did it a few years back, was bond ladders. So, exchange traded funds that hold bond ladders that mature at a set maturity date, so that way we can still use a pool of investment that’s a little bit more efficient to buy and sell, and we know when the maturity data is going to be, so we can act accordingly and adjust accordingly. So, there’s always this give and take, but using instruments like that, using individual bonds, are absolutely ways to take a little bit more control in the space and have less of a negative impact on the overall value of your portfolio.

 

John Teixiera: Yeah. And to jump in with what Nick’s saying there-

 

Nick McDevitt: Sure.

 

John Teixiera: … I think it comes down to ownership. When you have a bond fund, you don’t actually own those bonds, the fund does, you own a piece of the fund, but when you’re talking about individual bonds or this basket of bonds, that’s where you technically have ownership of that. So, you can control when it’s bought or sold.

 

Marc Killian: Okay. Yeah, that’s great information. Thanks so much for sharing that. So, guys, anything else that I might have missed on the bond, what we need to know area? Either one of you, feel free to jump in with something.

 

Nick McDevitt: I think from the perspective of overall for investors and just understanding in general the space that we’re in, one thing that we’ve done even recently is we’ve started to add in some shorter term CDs for clients, because that helps them get a decent rate of return because those rates of returns have gone up and it lets them stay a little bit more flexible with where we expect rates to go, which we still expect some increase on them in the next six to 12 months, where they can then stabilize a little bit. But just like anything else, it’s important to have … Different aspects of your investments have different jobs, and bonds and fixed income still play a necessary role. And realistically for people that are retired or are going to be retiring soon, a lot of the pressure on portfolios for the last 10 years has been all on the stock market because you really couldn’t get any returns on the fixed income side. So, now at least, hey, we can get four to 5% a lot easier on fixed income, which will help to generate returns and income for people, which it makes it a little bit easier for us to get a little bit more conservative in portfolios, which has been much more difficult over the last 10 years. So, there’s a little bit of a silver lining in here and as we adapt to a new normal like we always do, there will be positive to it. But when you’re in the midst of it and going through it, like we have this year, it can be difficult.

 

Marc Killian: Yeah, no, and that’s why I wanted to talk about it because again, we were taught this traditionalism and if you’re doing things on your own, you’re thinking, “Hey, I’ll just jump over to bonds, while the market’s been so rough this year after,” to your point, “the market being fantastic for the last 10, 12 years.” And it may or may not be a good move. Right? So, that’s just why, understand the basics, or maybe a little bit more than the basics, and then make sure that you’re having a conversation with an advisor. Bring somebody into the fold, especially if you don’t know what you’re dealing with, because there’s a lot out there in the bond arena. So, good stuff. Thanks for sharing on that, guys, I appreciate it. Again folks, if you’ve got questions and need help, jump on over to the website, book some time with them, reach out to them, let them know you’ve got some questions around bonds and how it works or what you’re thinking about doing, or strategy, conversation, questions, whatever that might be. And get some time with the guys at pfgprivatewealth.com. That’s pfgprivatewealth.com. A lot of good tools, tips and resources. You can send a message into the podcast. Like I said, you can schedule time to talk with the guys. Lots of good stuff there. So, pfgprivatewealth.com. And we’ll wrap it up with an email question again this week here on the podcast, Hoover wants to jump in on this, totally fine. Wendy had a question. She says, “Guys, our 401(k) plan at work now has a Roth option for available future contributions. Should I take advantage of that?” I’m curious too, guys, because actually my wife, they just offered that to her actually. She just got the paperwork I think about three days ago. So, what’s your thoughts on 401(k) Roth options?

 

Nick McDevitt: The annoying answer is it depends. The reality is that most likely it does make sense to take advantage of it. Some people cannot make contributions to regular Roth IRA accounts because the income is too high. So, this is their only way to be able to make contributions. Our feeling in general is that the more options you have from income sources in retirement, the better. So, especially if you don’t have any Roth funds built up or if your pre-tax funds are substantially more than your Roth funds, it’s a good idea to integrate that. And so, one thing that people have done to just start it, so as an example, let’s say that somebody’s contributing 10% of their income and maybe their company matches 4%. Okay? So, the match that a company puts in is always pre-tax. So, in reality, if they’re doing 10 and they get a 4% match, 14% of their income is going into pre-tax money. So, maybe you say, “Hey, out of my 10 I’m going to make it 4% Roth to match the match that they’re getting. The other 6% is pre-tax, and now it’s like 10 and four.” That could be a good place to start. And then maybe build it up where some people say, “Hey, each year when I get a raise, I bump up my contribution by a percent or 2% and try to build it up to make it match, until you’re maxing out.” But absolutely, building that up to build up some Roth funds for yourself is a good idea.

 

Marc Killian: Yeah. The limits, so if you think about a traditional Roth IRA, there’s earnings limits, right? You can only make a certain amount, I think it’s 144,000 for individuals, 214, somewhere in that neighborhood, I think, for married couples. And they change it all the time, but I think that’s ’22. But with a Roth 401(k) at work, there is no income limit. So, if she makes more than that, for example, she could still put money in.

 

Nick McDevitt: Exactly. Yeah. But you don’t have to deal with that income limitation anymore, which is great.

 

Marc Killian: And it’s a newer piece too, John, right? Not every company has this option yet, so they’re starting to come on more and more though.

 

John Teixiera: Yeah. Yeah, it is a newer piece. I’d say the majority of companies we run across now do have them.

 

Marc Killian: Okay, good.

 

John Teixiera: But I’d say we do run across some that still don’t offer it, but it’s catching on pretty quick because a lot of people do like that option.

 

Marc Killian: Yeah, for sure. So, I think definitely to answer the question, just make sure that you’re double checking, check the various different limitations. If you don’t have a professional you can bounce those questions off, certainly, hopefully the guys gave you some thoughts there. But you can always just call, reach out, and get a little bit more in-depth if you have some of those Roth 401(k) questions versus a Roth IRA, and those questions too, as well. But reach out to the guys, don’t forget to subscribe to the podcast, Apple, Google, Spotify, all that good stuff. It’s Retirement Planning – Redefined with John and Nick, and you can find them online at pfgprivatewealth.com. Guys, thanks for your time. As always, appreciate, have a good close out to the holiday season as that’s upon us, and we’ll see you guys next time here on Retirement Planning – Redefined.

4Q 2022 Recap & 1Q 2023 Outlook

Recapping A Challenging 2022

Markets faced several challenges in 2022, including high inflation, historic central bank policy, the war in Ukraine, and Covid lockdowns in China. Inflation was a major factor in the markets throughout the year, with the headline consumer price index reaching a 40-year high of 9.1% in June. High inflation prompted the Federal Reserve and its global central bank peers to aggressively raise interest rates, which caused stocks and bonds to trade lower. There was no place to hide as central banks rapidly tightened monetary policy. Figure 1 shows the S&P 500 returned -19.4% in 2022, its worst annual return since 2008, and Figure 5 shows the Bloomberg U.S. Bond Aggregate produced its worst total return since 1976. This letter reviews the fourth quarter, recaps a difficult 2022, and discusses what the market will be focused on in 2023.

Putting 2022’s Interest Rate Hikes Into Perspective

The main story of 2022 was the reversal of monetary policy from extraordinarily accommodative levels during the Covid-19 pandemic. Figure 2 shows the speed and size of interest rate increases as central banks worked to bring inflation under control. The chart tracks the cumulative percentage of interest rate increases and decreases by global central banks during rolling three-month periods since 1995. For example, the 68% at the end of November 2022 indicates that central banks across the globe raised interest rates by a total of 68% from September to November. In contrast, the total amount of interest rate cuts during that same period was only 4%. As the data shows, 2022 was the quickest, largest, and most imbalanced global tightening cycle since the late 1990s.

The pace of interest rate increases is forecasted to slow during 2023. Central banks continue to hint that they are approaching the end of their interest rate hike cycle, citing concerns that further tightening could push the economy into recession. In addition, data suggests price pressures are easing. While the year-over-year headline consumer price index rose by 7.1% in November 2022, which is still high compared to historical levels, it was down from the 9.1% rate seen in June 2022. As inflation and central bank policy return to normal, a new uncertainty is emerging – the unknown effects of 2022’s rate hikes.

Markets Wait for the Lagged Effect of Higher Interest Rates to Show Up in Economic Data

The Federal Reserve’s interest rate hikes occurred in 2022, but the full impact of its restrictive measures has not yet been fully felt in the real economy. While the U.S. economy contracted during the first half of 2022, it expanded at a robust +3.2% annualized pace during the third quarter. Consumer spending remained strong throughout most of 2022 despite high inflation, and the U.S. labor market added more than 4 million jobs through the end of November. The data indicates the U.S. economy has withstood tightening thus far, but the real test will come in 2023 as the cumulative impact of higher interest rates becomes clearer.

While a recession is not a foregone conclusion, it is possible the economy could be tested in 2023. An index of leading economic indicators shows the U.S. economy is already starting to slow as the impact of higher interest rates takes hold. Figure 3 graphs the month-over-month change in The Conference Board’s Leading Economic Index, which tracks ten economic components that tend to precede changes in the overall economy. Included in the components are the average weekly hours worked by manufacturing workers, new home building permits, and the volume of new orders for capital goods, such as equipment, vehicles, and machinery. The chart reveals that the Leading Economic Index has decreased every month since March 2022, an indication the economy is slowing after a period of strong growth during the pandemic recovery.

Equity Valuations Are More Attractive, But Corporate Earnings Are An Open Question

Whereas inflation and central bank policy were the primary drivers of markets in 2022, economic data and corporate fundamentals are expected to play a larger role in determining the market’s direction in 2023. Figure 4 tracks two important S&P 500 metrics. The top chart tracks the next 12-month price-to-earnings ratio, which divides the S&P 500’s projected next 12-month earnings by its current price. It shows valuation multiples expanded during the pandemic as interest rates were cut to near 0% before reversing lower during 2022 as rising interest rates weighed on company valuations.

While current valuations are at a more attractive starting point today than at the beginning of 2022, corporate earnings are an open question entering 2023 with the potential for an earnings reset as the economy slows. The bottom chart in Figure 4 tracks the S&P 500’s trailing 12-month earnings growth, showing the jump in corporate earnings during the pandemic. Despite expectations for an economic slowdown, Wall Street analysts still forecast single-digit earnings growth for the S&P 500 in 2023. The positive earnings growth forecast is encouraging, but it creates a risk for the market. If actual earnings growth falls short of the forecast, stock prices could decline as markets price in lower actual earnings.

Equity Market Recap – Stocks Trade Higher in 4Q’22

Stocks traded lower during December but still ended the fourth quarter higher. The S&P 500 Index of large cap stocks returned +7.6% during the fourth quarter, outperforming the Russell 2000 Index’s +6.2% return. The Dow Jones Index, which includes large companies such as Visa, Caterpillar, Nike, and Boeing, was the top performer, returning +15.9%, while the Nasdaq 100 Index of technology and other growth-style stocks produced a -0.1% return during the fourth quarter.

Energy was the top performing S&P 500 sector during the fourth quarter, followed by the cyclical sector trio of Industrials, Materials, and Financials. Defensive sectors, including Health Care, Consumer Staples, and Utilities, were middle of the pack performers. Growth-style sectors, including Technology, Communication Services, and Consumer Discretionary, and interest-rate sensitive Real Estate underperformed as higher interest rates continued to weigh on valuation multiples.

International stocks outperformed U.S. stocks during the fourth quarter. The MSCI EAFE Index of developed market stocks returned +17.7% during the fourth quarter, while the MSCI Emerging Market Index returned +10.3%. A weaker U.S. dollar boosted the returns of international stocks, with U.S. dollar weakness driven by a shrinking monetary policy gap as other central banks catch up with the Federal Reserve’s aggressive policy. Separately, China’s decision to relax its Covid-zero restrictions raised the prospect of stronger global growth as one of the world’s biggest economies reopens.

Bond Market Recap – The Great 2022 Yield Reset

The bond market experienced a significant resetting of interest rates during 2022, with yields steadily rising as the Federal Reserve pushed through large interest rate hikes. Despite posting positive returns during the fourth quarter, bonds produced significant losses during 2022 as central banks raised interest rates at a rapid pace. The top chart in Figure 5 shows the Bloomberg U.S. Bond Aggregate produced a -13% total return during 2022, its biggest negative total return since tracking began in 1976. The bottom two charts in Figure 5 examine the current state of the credit market after 2022’s rate hikes. The middle chart shows the 10-year Treasury yield sits at its highest level since 2007. Yields are now higher across most credit classes, and investors can earn a yield of around 4% to 5% on a portfolio of high-quality bonds, such as U.S. Treasury bonds and investment grade corporate bonds, without locking up capital for long periods of time. In the corporate credit market, the bottom chart shows the high-yield corporate bond spread, which is the extra yield investors demand to loan to lower quality borrowers, is in line with its median since 1999.

The starting point for bonds, both in terms of yield and credit spreads, is now more compelling than it has been in a long time. However, there is still the potential for continued volatility in the bond market. There is still significant uncertainty regarding how high the Fed will need to raise interest rates and how long it will need to keep interest rates at restrictive levels to bring inflation down to normal levels. There is a risk that inflation could remain above the Fed’s 2% target, leading to an extended tightening cycle. At the same time, the economy is likely to start feeling the effects of 2022’s rate hikes in 2023, which could make bonds more attractive. The crosscurrents of uncertain central bank policy and a volatile global economy could keep interest rate volatility elevated and test bond investors’ nerves again during 2023.

2023 Outlook – Turning the Page on 2022’s Historic Tightening Cycle

2023 brings the next phase of the tightening cycle where the lagged effects of tighter monetary policy will be felt. It has the potential to be a year of two halves. In the first half, the focus is likely to shift from the number of future interest rate hikes to how much those interest rate hikes will slow the economy. Some data, such as the housing market, indicate that tighter monetary policy is being transmitted into the economy at a rapid pace. Home sales are slowing, and homebuilder confidence weakened every month during 2022 and now sits at its lowest level since 2012. At the same time, consumers continue to spend, and employers continue to add jobs. There is still a wide range of possible outcomes, and the unique nature of the pandemic followed by rapid interest rate cuts and hikes makes the path forward less certain.

The second half has the potential to be different depending on how severe the slowdown is in early 2023. Markets are based on forward-looking decisions, and investors will be watching closely for signs that the economy has bottomed and is recovering. Plus, Figure 1 contains an encouraging historical trend. The chart shows there have only been two instances of consecutive negative S&P 500 return years since 1950, in 1973-1974 and 2000-2002. This does not necessarily mean the S&P 500 will produce a positive return in 2023 or trade higher in a straight line from here, because it may not. However, it does provide helpful historical context in a volatile environment.

Wishing you and your family happiness and health in the New Year! We look forward to serving you another year.

Important Notices & Disclaimer

The information and opinions expressed herein are solely those of PFG Private Wealth Management, LLC (PFG), are provided for informational purposes only and are not intended as recommendations to buy or sell a security, nor as an offer to buy or sell a security. Recipients of the information provided herein should consult with their financial advisor before purchasing or selling a security.

The information and opinions provided herein are provided as general market commentary only, and do not consider the specific investment objectives, financial situation or particular needs of any one client. The information in this report is not intended to be used as the primary basis of investment decisions, and because of individual client objectives, should not be construed as advice designed to meet the particular investment needs of any investor.

The comments may not be relied upon as recommendations, investment advice or an indication of trading intent. PFG is not soliciting any action based on this document. Investors should consult with their financial adviser before making any investment decisions. There is no guarantee that any future event discussed herein will come to pass. The data used in this publication may have been obtained from a variety of sources including U.S. Federal Reserve, FactSet, Bloomberg, Bank of America Merrill Lynch, iShares, Vanguard and State Street, which we believe to be reliable, but PFG cannot be held responsible for the accuracy of data used herein. Any use of graphs, text or other material from this report by the recipient must acknowledge MarketDesk Research as the source. Past performance does not guarantee or indicate future results.   Investing   involves   risk,   including   the possible loss of principal and fluctuation of value. PFG disclaims responsibility for updating information. In addition, PFG disclaims responsibility for third-party content, including information accessed through hyperlinks.

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Wage Inflation Puts Additional Pressure on the Federal Reserve

Inflation remains a closely watched topic in financial markets. Core inflation, which excludes volatile food and energy prices, increased +6.6% year-over-year during September. It was the fastest annual pace since August 1982 and signals inflation’s persistence. Early inflation pressures were attributed to clogged supply chains and strong demand overwhelming limited supply, but a new source of inflation is gaining attention as supply chains normalize – wage inflation.

Figure 1 shows hourly wages increased +5% year-over-year during September. The growth rate, which is significantly above the pre-pandemic trend, indicates labor demand is outpacing labor supply and employers are paying more to attract and retain workers. What is causing the labor supply / demand imbalance? Data shows millions of workers left the labor market during the pandemic and have not returned.

Figure 2 graphs the number of people not in the labor force, which is defined as persons who are neither employed nor unemployed. This category includes retired persons, students, individuals taking care of children or other family members, and others who are neither working nor seeking work. The chart shows 95 million individuals were not in the labor force at the end of February 2020. The number spiked to 103.5 million at the end of April 2020 as workers left the labor market due to virus and health concerns, childcare responsibilities, and early retirements. While some of those individuals returned to the labor market, there are nearly 5 million more people not in the labor force at the end of September 2022.

Wage inflation is yet another factor complicating the Federal Reserve’s goal to bring under inflation control. Bringing the labor market back into equilibrium could ease wage inflation, but it could also significantly increase unemployment. Despite the near-term employment risk, the Fed views the risk of inflation becoming entrenched as a bigger long-term risk. All eyes will be on the labor market in coming months.

The information and opinions expressed herein are solely those of PFG Private Wealth Management, LLC (PFG), are provided for informational purposes only and are not intended as recommendations to buy or sell a security, nor as an offer to buy or sell a security. Recipients of the information provided herein should consult with their financial advisor before purchasing or selling a security.

Important Notices & Disclaimer

The information and opinions expressed herein are solely those of PFG Private Wealth Management, LLC (PFG), are provided for informational purposes only and are not intended as recommendations to buy or sell a security, nor as an offer to buy or sell a security. Recipients of the information provided herein should consult with their financial advisor before purchasing or selling a security.

The information and opinions provided herein are provided as general market commentary only, and do not consider the specific investment objectives, financial situation or particular needs of any one client. The information in this report is not intended to be used as the primary basis of investment decisions, and because of individual client objectives, should not be construed as advice designed to meet the particular investment needs of any investor.

The comments may not be relied upon as recommendations, investment advice or an indication of trading intent. PFG is not soliciting any action based on this document. Investors should consult with their financial adviser before making any investment decisions. There is no guarantee that any future event discussed herein will come to pass. The data used in this publication may have been obtained from a variety of sources including U.S. Federal Reserve, FactSet, Bloomberg, Bank of America Merrill Lynch, iShares, Vanguard and State Street, which we believe to be reliable, but PFG cannot be held responsible for the accuracy of data used herein. Any use of graphs, text or other material from this report by the recipient must acknowledge MarketDesk Research as the source. Past performance does not guarantee or indicate future results.   Investing   involves   risk,   including   the possible loss of principal and fluctuation of value. PFG disclaims responsibility for updating information. In addition, PFG disclaims responsibility for third-party content, including information accessed through hyperlinks.

No mention of a particular security, index, derivative or other instrument in the report constitutes a recommendation to buy, sell, or hold that or any other security, nor does it constitute an opinion on the suitability of any security, index, or derivative. The report is strictly an information publication and has been prepared without regard to the particular investments and circumstances of the recipient.

READERS   SHOULD   VERIFY   ALL   CLAIMS   AND   COMPLETE    THEIR    OWN RESEARCH AND CONSULT A REGISTERED FINANCIAL PROFESSIONAL BEFORE INVESTING IN ANY INVESTMENTS MENTIONED IN THE PUBLICATION. INVESTING IN SECURITIES AND DERIVATIVES IS SPECULATIVE AND CARRIES A HIGH DEGREE OF RISK, AND READERS MAY LOSE MONEY TRADING AND INVESTING IN SUCH INVESTMENTS. PFG Private Wealth Management, LLC is a registered investment advisor.

Providing Context on Recent Market Volatility

Monthly Market Summary

  • The S&P 500 Index returned -4.1% during August, underperforming the Russell 2000 Index (-2.0%) for a second consecutive month.
  • Energy (+2.7%) was the top-performing S&P 500 sector during August despite oil prices falling -9.7%. Utilities (+0.5%) was the only other sector to produce a positive return. Technology (-6.2%) was the worst performing sector as interest rates rose, followed closely by Health Care (-5.8%) and Real Estate (-5.6%).
  • Corporate investment grade bonds generated a -4.4% total return, slightly underperforming corporate high yield bonds’ -4.3% total return.
  • The MSCI EAFE Index of global developed market stocks returned -6.1% during August, underperforming the MSCI Emerging Market Index’s -1.3% return.

Stock & Bond Markets Endure a Bumpy August After July’s Gains

The S&P 500 produced a -4.1% return during August, but the headline number doesn’t tell the full story. Equity markets initially rallied during the first half of the month, with the S&P 500 gaining +4.2% through August 16th as July’s market rally continued. However, the second half of August marked a sharp reversal as the S&P 500’s gave back all its gains plus more. Credit markets also experienced a reversal during August as interest rates reversed higher and bonds produced negative returns. The increased volatility across stock and bond markets is being attributed to a wide range of investor views creating a tug of war effect in markets, as well as uncertainty regarding how long the Federal Reserve will continue to raise interest rates.

Federal Reserve Chair Pushes Back Against Hopes for Policy Pivot

The Federal Reserve held its annual August Jackson Hole meeting, and Chair Powell used his speech to forcefully push back against the notion the Fed will pivot and cut interest rates if economic data starts to weaken. Powell emphasized the central bank’s “overarching focus right now is to bring inflation back down to our 2 percent goal” and cautioned, “Reducing inflation is likely to require a sustained period of below-trend growth … [and] will also bring some pain to households and businesses.”

Investor hopes for a Fed pivot were one of the primary catalysts that propelled the stock market higher during July and August. Chair Powell’s speech dashed those hopes and sent the S&P 500 down more than -3% on the day of his speech. Why? Two lines from Chair Powell’s speech underscore the Fed’s goal, “There is clearly a job to do in moderating demand to better align with supply. We are committed to doing that job.” This focus on lowering demand for goods and services may increase portfolio volatility during the months ahead as investors debate how long it will take the Fed to achieve its goal and the impact tighter policy will have on the economy.

Important Notices & Disclaimer

The information and opinions expressed herein are solely those of PFG Private Wealth Management, LLC (PFG), are provided for informational purposes only and are not intended as recommendations to buy or sell a security, nor as an offer to buy or sell a security. Recipients of the information provided herein should consult with their financial advisor before purchasing or selling a security.

The information and opinions provided herein are provided as general market commentary only, and do not consider the specific investment objectives, financial situation or particular needs of any one client. The information in this report is not intended to be used as the primary basis of investment decisions, and because of individual client objectives, should not be construed as advice designed to meet the particular investment needs of any investor.

The comments may not be relied upon as recommendations, investment advice or an indication of trading intent. PFG is not soliciting any action based on this document. Investors should consult with their financial adviser before making any investment decisions. There is no guarantee that any future event discussed herein will come to pass. The data used in this publication may have been obtained from a variety of sources including U.S. Federal Reserve, FactSet, Bloomberg, Bank of America Merrill Lynch, iShares, Vanguard and State Street, which we believe to be reliable, but PFG cannot be held responsible for the accuracy of data used herein. Any use of graphs, text or other material from this report by the recipient must acknowledge MarketDesk Research as the source. Past performance does not guarantee or indicate future results.   Investing   involves   risk,   including   the possible loss of principal and fluctuation of value. PFG disclaims responsibility for updating information. In addition, PFG disclaims responsibility for third-party content, including information accessed through hyperlinks.

No mention of a particular security, index, derivative or other instrument in the report constitutes a recommendation to buy, sell, or hold that or any other security, nor does it constitute an opinion on the suitability of any security, index, or derivative. The report is strictly an information publication and has been prepared without regard to the particular investments and circumstances of the recipient.

READERS   SHOULD   VERIFY   ALL   CLAIMS   AND   COMPLETE    THEIR    OWN RESEARCH AND CONSULT A REGISTERED FINANCIAL PROFESSIONAL BEFORE INVESTING IN ANY INVESTMENTS MENTIONED IN THE PUBLICATION. INVESTING IN SECURITIES AND DERIVATIVES IS SPECULATIVE AND CARRIES A HIGH DEGREE OF RISK, AND READERS MAY LOSE MONEY TRADING AND INVESTING IN SUCH INVESTMENTS.

PFG Private Wealth Management, LLC is a registered investment advisor.

Declining Labor Productivity & Rising Labor Costs

This month’s chart looks at a trend not seen in decades – declining labor productivity and rising labor costs. Figure 1 shows labor productivity, which is measured as economic output per hour worked, declined -2.5% year-over-year during the second quarter. The -2.5% decline in labor productivity is the largest decline in the data series, which began in the first quarter of 1948. Hourly compensation rose +6.7% year-over-year as a tight labor market drove strong wage growth.

A look at the underlying data provides additional context on declining productivity. Total output rose +1.5% compared to the same quarter a year ago, while hours worked rose a bigger +4.1% year-over-year. The data indicates workers produced more goods and services less efficiently. Why is productivity declining? One potential explanation is pandemic-related themes, such as remote work and inflation, make the process of measuring productivity more difficult and distort the data.

Thematic changes may also explain the productivity decline. The labor market experienced significant turnover during the pandemic, and it takes time for workers to learn new jobs. As an example, Delta’s CEO pointed to labor turnover as a cause of the airline’s recent operational issues: “Since the start of 2021, we’ve hired 18,000 new employees, and our active head count is at 95% of 2019 levels, despite only restoring less than 85% of our capacity. The chief issue we’re working through is not hiring, but of training and experience bubble.” In addition, capacity constraints may also be weighing on productivity. The capacity utilization rate, which measures the amount of potential output that is actually being realized, was 80% during June 2022. The peak utilization rate over the past 20 years was ~81%, suggesting businesses may be running up against the limit of how much capacity they can use efficiently.

The combination of declining productivity and rising compensation costs is a notable trend, and it remains to be seen whether it is a short-term phenomenon or start of a longer-term trend. One trend we will be monitoring in coming quarters is whether decreased efficiency and rising labor costs negatively impact profit margins.

Important Notices & Disclaimer

The information and opinions expressed herein are solely those of PFG Private Wealth Management, LLC (PFG), are provided for informational purposes only and are not intended as recommendations to buy or sell a security, nor as an offer to buy or sell a security. Recipients of the information provided herein should consult with their financial advisor before purchasing or selling a security.

The information and opinions provided herein are provided as general market commentary only, and do not consider the specific investment objectives, financial situation or particular needs of any one client. The information in this report is not intended to be used as the primary basis of investment decisions, and because of individual client objectives, should not be construed as advice designed to meet the particular investment needs of any investor.

The comments may not be relied upon as recommendations, investment advice or an indication of trading intent. PFG is not soliciting any action based on this document. Investors should consult with their financial adviser before making any investment decisions. There is no guarantee that any future event discussed herein will come to pass. The data used in this publication may have been obtained from a variety of sources including U.S. Federal Reserve, FactSet, Bloomberg, Bank of America Merrill Lynch, iShares, Vanguard and State Street, which we believe to be reliable, but PFG cannot be held responsible for the accuracy of data used herein. Any use of graphs, text or other material from this report by the recipient must acknowledge MarketDesk Research as the source. Past performance does not guarantee or indicate future results.   Investing   involves   risk,   including   the possible loss of principal and fluctuation of value. PFG disclaims responsibility for updating information. In addition, PFG disclaims responsibility for third-party content, including information accessed through hyperlinks.

No mention of a particular security, index, derivative or other instrument in the report constitutes a recommendation to buy, sell, or hold that or any other security, nor does it constitute an opinion on the suitability of any security, index, or derivative. The report is strictly an information publication and has been prepared without regard to the particular investments and circumstances of the recipient.

READERS   SHOULD   VERIFY   ALL   CLAIMS   AND   COMPLETE    THEIR    OWN RESEARCH AND CONSULT A REGISTERED FINANCIAL PROFESSIONAL BEFORE INVESTING IN ANY INVESTMENTS MENTIONED IN THE PUBLICATION. INVESTING IN SECURITIES AND DERIVATIVES IS SPECULATIVE AND CARRIES A HIGH DEGREE OF RISK, AND READERS MAY LOSE MONEY TRADING AND INVESTING IN SUCH INVESTMENTS.

PFG Private Wealth Management, LLC is a registered investment advisor.