Market Commentary 08/02/23

Last week the Fed raised interest rates by 0.25%, reaching a 22-year high of 5.50%. The announcement offered little new information, with the press release virtually unchanged from June. Chair Powell reiterated previous talking points and left the door open for further rate increases. However, two key headlines caught our attention: (1), the Federal Reserve is no longer forecasting a recession and (2) Powell does not expect a 2% inflation rate to be achieved in the coming year. As a result, the Fed’s ongoing approach may be uncertain, caught between doing too much or too little.

Additionally, the Consumer Confidence Index rose to 117.0 in July, the highest since July 2021. Consumers appear to be optimistic about the economy, including business and labor market conditions. The Expectations Index also improved, pointing to confidence in future business and job prospects. Consumers remain upbeat despite higher rates, possibly due to a leveling of inflation and a still robust labor market.

Generally, investors can earn income in one of two primary ways – dividends paid on stocks or interest paid on bonds. While both generate income, stocks and bonds have very different risk profiles. Stocks tend to be more volatile than bonds because stocks are more sensitive to the state of the economy and changes in a company’s financial performance. Stocks also face a higher degree of income uncertainty since companies may choose, but are not obligated, to pay dividends to shareholders. Conversely, borrowers are contractually required to pay interest on their bonds at specified intervals. Bondholders also rank higher in a company’s capital structure and are typically paid back before stockholders if a company declares bankruptcy. While bonds tend to produce lower returns, their contractual interest payments and seniority may make them a less risky income source.

The last decade of low interest rates made it difficult for bond investors and savers to generate income. Due to historically low interest rates, if savers wanted to earn more income than bonds offered, they had to consider purchasing dividend paying stocks. From 2008 through 2022, many S&P 500 companies offered higher yields than the 5-year Treasury bond. However, this dynamic has changed during the past 12 months as interest rates have been rising. As of July 11th, only 51 companies in the S&P 500 paid a dividend yield above the yield on a 5-year Treasury bond, the fewest since 2007, a period when savers could generate more income by owning bonds rather than stocks.

Bonds sold off in 2022 as the Federal Reserve raised interest rates, but the higher interest rates present an opportunity for bond investors and savers. Fixed income securities are now paying more competitive rates for those who want to invest for income. Yields on shorter maturity Treasuries approach 5.5%, and investors can lock in a yield near 4% on longer maturity Treasuries. Rather than relying on stocks to generate income, savers can now earn a higher level of income by owning bonds and diversifying their portfolio. With higher interest rates, investors may be less incentivized to purchase stocks, especially if corporate earnings growth has slowed.

While the market has performed well year to date, we are paying close attention to rising rates, equity valuations, and ongoing inflation inputs to best gauge how well these “good times” can last.