THE markets are mercurial but their tone has thoroughly changed – from the sky-is-the-limit bullishness that dominated only a month ago to a mood of heightened uncertainty and measured self-restraint.
Big shifts have taken place this month. Bonds have taken a beating but are becoming increasingly attractive. Stocks are no longer rocketing straight to the heavens. The US dollar has strengthened and there are new reasons to worry about a steep increase in the price of oil.
Behind many of these changes are two familiar culprits: inflation and interest rates. Lurking in the background are heightened geopolitical risks. The possibility of a widening conflict in the Middle East – and of rising oil prices feeding into inflation in the United States – surfaced again on Friday (Apr 19) when Israel struck Iran.
None of this is terribly alarming for markets at this point – at least not for long-term investors who can handle a bit of turmoil. But consider this: For the first three months of 2024, US stocks rose relentlessly, while bonds posted modest gains, amid expectations of a series of cuts in the short-term interest rates controlled by the Federal Reserve. Now, successive months of high inflation readings have dashed those hopes – or, at the very least, deferred them.
“It’s appropriate to allow restrictive policy further time to work and let the data and the evolving outlook guide us,” Jerome Powell, the Fed’s chair, said last Tuesday. In plain English, barring an emergency, you can now expect short-term interest rates to remain at elevated levels for months to come.
At the same time, the market-based interest rates that rule the world of bonds have generally moved higher. The benchmark 10-year Treasury note – perhaps the most important single benchmark in the global bond universe – jumped 0.7 percentage points since the start of the year. That’s a colossal gain in the staid world of bonds, pushing yields last week above 4.65 per cent, their highest point since November.
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Stocks have given up ground, and in futures markets, the price of oil has climbed as much as 18 per cent this year. Brent crude, the global benchmark, is hovering near US$90 a barrel. Futures markets show that traders expect the price of oil to decline over the next year, but an escalation of the conflict between Israel and Iran could transform that outlook in an instant.
Iran and Israel
Iran is a major power in the Persian Gulf, and to call this region geopolitically significant badly understates the case. In particular, the Strait of Hormuz, between Iran and Oman, ranks as “the world’s most important oil choke point”, the US Energy Information Administration says. About 21 per cent of global petroleum liquids consumption flowed through it in 2022, the agency estimates. If traders were even to begin to panic about the vulnerability of oil there, prices would shoot higher.
At US$100 a barrel – or, even worse, at US$110 or US$120 – steeper oil prices would “bleed into core inflation, potentially slowing its descent towards the Fed’s target”, said an analysis by Oxford Economics, an independent research firm.
The Persian Gulf is hardly the only geopolitical hot spot. Recall that in June 2022, early in the Russia-Ukraine war, Brent oil exceeded US$120 a barrel. That war could disrupt oil supplies again, too.
For truly long-term investors who buy and hold stocks and bonds through low-cost index funds, shifts like these will, quite likely, be no big deal. Over the course of the next 20 years or more, it’s likely that they will be scarcely remembered.
That, at least, is my hope, based on history. But if your comfortable investment horizon is short, or you simply want to know what’s happening to your holdings, April has started out as a cruel month, even if it’s too early to say that it is the cruellest.
Whether we’re experiencing a brief pause in a bull market or the start of something more consequential can’t be known in advance. There’s little doubt, though, that the momentum of the markets has wavered.
Bonds
Bond yields are much higher than they were a few months ago. That’s hurt bond returns this year, but it’s also made bonds more attractive when compared with stocks.
“Bonds look quite good now, on a relative, historical basis,” said Andy Sparks, managing director and head of portfolio management research at MSCI, a financial services company. “Of course, we’ve been saying that for a while,” he added ruefully.
While most bond funds had gains in the first three months of the year, rising interest rates by now have plunged many of them into the red. The Bloomberg US Aggregate Index, and a fund that tracks it, the iShares Core Aggregate US Bond ETF, are down around 3 per cent in 2024. Longer term Treasury bonds, of 20 years or more in duration, and the iShares 20+ Year Treasury Bond ETF, which tracks such bonds, have fallen 9 per cent this year.
What makes those declines painful is that they are occurring not long after the mammoth declines of 2022: a return of minus 13 per cent for the Aggregate index and minus 31 per cent for long Treasuries. Returns in 2023 weren’t bad, but they didn’t come close to making up for 2022’s losses, and now bonds have declined in value again.
That’s entirely because of inflation and interest rates. When rates go up, bond prices fall. That’s the way bond math works.
Despite these setbacks, there is some good news in the bond market.
With higher yields, bonds are generating much more income for investors. If rates drop from here, bond prices will rise. And on a comparative basis (using metrics like the earnings yield of the S&P 500 – essentially, the inverse of the price-to-earnings ratio), higher yields generally make bonds look better than they have in years.
What’s more, should hotter wars break out in the Middle East or Eastern Europe – or if the stock market should plunge sharply for many other reasons – there’s a good chance that investors seeking a safe spot to park their money will gravitate towards US Treasuries once again. Increased demand would probably raise bond prices and lower yields, producing profits for current bond investors.
I’d add one major caveat, however. If inflation were to rise further, interest rates would probably follow, leading to bond losses. That happened in a big way in 2022, and it has been echoed, in a much fainter way, this month.
Stocks
The stock market’s performance was nothing short of meteoric through March. Because of that, the S&P 500 is still up about 4 per cent in 2024 and 19 per cent for the past 12 months. But at the end of March, those numbers were 10 per cent for the year and 28 per cent over 12 months.
For most of this year, enthusiasm for artificial intelligence fuelled a rally reminiscent of the dotcom boom of 1998 to 2000. That earlier bull market became a bubble that burst. Today, a slowdown in the market’s momentum could turn out to be a good thing if it gives the new technology a little time to permeate the economy, engender productivity gains and generate profits for a broad range of companies.
But this year, there are signs that the market may have gotten ahead of itself. Consider that through March, almost 80 per cent of the companies in the S&P 500 had positive returns for the calendar year. For the month of April, more than 90 per cent of S&P 500 companies have declined.
Fossil fuel companies such as Exxon Mobil have risen, with tensions in the Middle East contributing to their gains. For the calendar year, Exxon has returned about 20 per cent, including dividends. While an oil shock would hurt most stocks, it would be a boon for oil companies – a reminder of why, from a purely financial standpoint, it pays to diversify.
Other asset classes are shifting in value as well. The US dollar, which declined from November to the end of 2023, has been rising lately. Comparative global interest rates are the simplest explanation. The Bank of Switzerland has already cut its benchmark rate and the European Central Bank says it’s likely to follow suit. While the Bank of Japan raised rates in March for the first time in 17 years, interest rates there are so low compared with the United States that the yen has been stuck in a weak position. With the Fed unlikely to lower short-term rates soon, the US dollar has been surging – giving US travellers abroad greater spending power, but worsening the terms of trade for a broad range of US companies.
What’s safe to say is that broad diversification across asset classes has helped stabilise long-term investment returns. Since 2007, MSCI estimates that world stock markets have gained 7.4 per cent, annualised, while the US stock market has had a 9.8 per cent gain. US government bonds have returned 2.5 per cent.
As an investor, based on returns like these, I hold mainly stocks, with a sizable dollop of bonds, all through low-cost index funds, and try not to pay much attention to market shifts over weeks, months or even years. It’s worked before, and while there are no guarantees, I think it’s likely to work over the long haul, too. NYTIMES
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