The Return of Reasonable Alternatives

Friday Reflection

The Fed’s interest rate decisions were influencing stock and bond markets long before they emerged as a catalyst for last year’s price declines. Instead of rising rates, it was radically low rates that were the central theme for almost 14 years from the end of the 2008 financial crisis up until 2022. This period of artificially suppressed rates – often near zero – had a multitude of financial consequences that we’re still dealing with. One was the rise of the acronym TINA, or There Is No Alternative, in reference to the US stock market. Many pundits believed that ultra-low banking and bond rates meant that stocks were the only option for investors looking to achieve long-term growth.

That is no longer the case. Yields on corporate bonds and Treasuries have increased to attractive levels, and cash reserves are paying noticeable interest. Diversified investors are once again being rewarded for taking a more balanced and measured approach to investment risk. While the transition period is not over yet, these more normalized interest rates will have positive ramifications for investors and the broader economy.

A Spectrum of Investors

A decade of near-zero percent interest rates pressured investors to opt for greater risk in their portfolios than they were comfortable taking. Many decided to invest more of their cash savings because their bank account wasn’t paying anything meaningful. This was, in fact, a primary goal of the Fed’s zero percent rate policy: forcing consumers to spend or invest rather than saving their money, with the hope that this would stimulate the economy.

Other investors decided to tilt their portfolio further towards stocks due to FOMO, or Fear of Missing Out, when they saw the outsized gains produced by the S&P 500. This strategy worked for multiple years, rewarding investors who decided to take on greater and greater levels of risk in their portfolios. When inflation roared back last year, it caused equity prices to fall precipitously as the Fed aggressively raised rates. Some investors took this in stride as they understood the ups and downs of long-term market cycles. Others realized that they had taken more risk than they could tolerate during this period of distorted policy, and now faced the difficult decision between selling and de-risking at lower prices or maintaining their allocations while waiting for a future recovery.

Today’s higher interest rates offer some relief to investors seeking a more balanced approach. Not all investors are interested in taking on substantial risk in exchange for higher growth rates, with many simply wanting to keep up with inflation and support retirement distributions. For these investors, 4-5% yields on corporate bonds and Treasuries are a welcome sight and offer less volatility than stock investments – even if inflation is still above those levels for the moment. Some high-yield savings accounts are even providing 3% growth with no risk to the cash that’s deposited, restoring the value and stability of keeping cash reserves.1

Dynamic Economies Need Alternatives

Another downside of zero percent rates was the impact it had on capital allocation across our economy. One of the hallmarks of a free market is the existence of competition, which should ultimately benefit the consumer. Good businesses with high quality products attract customers and investors, which leads to growth; poorly run businesses don’t attract new capital and investment, and they eventually close. Enormous modern economies are full of complexity and nuance, but this simple description typically holds true as long as interest rates are at normal levels. 

During the decade following the financial crisis through 2021, interest rates were not at normal levels. Businesses were able to borrow new debt from banks at ultra-low interest rates and attracted capital from investors who feared the alternative of sitting in cash and earning nothing. The abundance of “free money” led many businesses to make short-term decisions that were unsustainable and dependent on low rates.

In a world of higher rates and higher cost of capital, businesses are being forced to be more discerning when considering new projects. Good companies will continue to attract capital, but subpar companies and ideas will be allowed to fail. This renewed landscape should create a much healthier economy in the long run.

Normalization Takes Time

While we are encouraged by the expanded set of options for investors seeking more balanced returns, the transition to a healthier economic landscape will take time. Inflation is still running well above Fed targets, national and global politics are keeping investors on edge, and the US economy is facing the possibility of a recession. The Fed’s 2022 rate hikes impacted stock and bond markets immediately, but there is often a 12 to 18-month lag before they fully impact the economy, inflation, and consumer spending.2

Markets are starting this year from more reasonable valuations and with bonds yielding stronger income than prior years. Regardless of what the Fed ultimately does with interest rates over the coming months, this balance should benefit patient investors and diversified portfolios as they navigate short-term storms and begin rebuilding portfolio values.

Resources
1 Summary of Best Savings Accounts of February 2023 Nerdwallet.com
2 How long does it take for Fed rate hikes to work? Marketplace.org

Brian Kozel, CFP 

About Brian Kozel, CFP®

Brian Kozel is a Partner at North Berkeley Wealth Management. Brian helps clients feel confident as they navigate their financial journey.

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This commentary on this website reflects the personal opinions, viewpoints, and analyses of the North Berkeley Wealth Management (“North Berkeley”) employees providing such comments, and should not be regarded as a description of advisory services provided by North Berkeley or performance returns of any North Berkeley client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. North Berkeley manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

By |2023-03-10T12:49:58-08:00February 24th, 2023|