It’s been a stormy winter for the financial markets. Is springtime near, or is an even bigger storm brewing?
If you don’t enjoy roller coasters, you probably did your best to ignore the financial markets in January. Wall Street’s ups and downs were as hair-raising as they come. The ride smoothed out a bit by the end of the month – but is the scary part really over? I’ll cover: What’s up – or down – with the stock market; interest rates and inflation; what spring might bring; and what it all means for income investors.
If you think of the stock market as a rollercoaster, the January ride began with all the cars clicking their way up to a new peak high. On January 4th the S&P 500 reached 4,796 points, and a day later the Dow made it to 36,799 – both new record highs. Of course, a rollercoaster is propelled by downward momentum, and that kicked in mid-month. By January 21st the Dow was down by over 2,000 points, and on January 24th, the S&P 500 officially entered correction territory, meaning it was down more than 10 percent. So, what were the main drivers of all this volatility? There were at least four: One, of course, was inflation. The second was the Fed, which announced in December it would start raising short-term interest rates again this year to help deal with inflation. The third issue was long-term interest rates, which rose faster in January than at any time since January of 2020. The fourth issue was corporate earnings. Investors were anxiously awaiting the results of fourth-quarter earnings reports, given that economic growth had stalled in the third quarter of 2021. But let’s take a closer look at two of these issues: inflation and interest rates.
The inflation rate reached 7 percent in December, marking the fastest month-to-month rise in prices since June of 1982. Although inflation has caused occasional market volatility over the past year, there are at least three reasons it hasn’t caused more – so far. One is that investors factor inflation into their projections, and most have been expecting this bout to get worse before it gets better. Two, as a result of three massive economic relief bills and the Fed’s quantitative easing efforts, there is still a ton of money flowing through the US economy. And three, both short- and long-term interest rates are still relatively low. The first creates an incentive for people to borrow money, and the second creates an incentive for people to invest in the stock market by making other investment options seem less attractive. Both outcomes help drive economic growth. And that growth did return after faltering last summer. In the fourth quarter, real GDP grew at a seasonally adjusted annualized rate of 6.9 percent. The recovery was largely a result of holiday spending and the fact that the omicron variant wasn’t yet a major concern last year. But that changed in January, and so did the interest rate factor. Bond yields across the board have risen significantly in the new year – mainly in anticipation of the Fed’s stated plan to raise short-term rates.
At its January meeting, the Fed has said it plans to start raising rates in March and may approve up to three more rate hikes this year. What will that mean for long-term rates and the stock market? Well, here are three important things to know about the Fed’s plan: First, raising short-term rates helps lower inflation by decreasing demand because people tend to spend less when borrowing costs are higher. Second, decreasing demand also, by its nature, slows economic growth. And third, raising short-term rates does nothing to address supply shortages, which are half the problem with today’s inflation. What all this means is that timing will be crucial for the Fed. Despite the economy’s rebound in the fourth quarter, investors still seem uncertain about how strong it really is. If the Fed’s initial rate hike in March coincides with bad first quarter earnings projection or another big jump in inflation, that could send the markets into a tailspin.
So, what does all of this mean for income investors? Well, first remember that long-term interest rates also spiked early last year. It’s a well-known fact that rising interest rates create headwinds for income investors because when interest rates rise, bond values fall. But, as I always point out, it’s not that simple. Interest rates aren’t the only things that affect bond values. Another important factor is credit spread compression, which helps create a “natural softener” for income investors that helps minimize the impact of rising interest rates on your portfolio overall. Last year’s first-quarter rate spike offered a great example of this. The point is, income investors can count on credit spread compression – along with certain active management strategies – to work in their favor if interest rate spikes continue this year. More importantly, any loss in value in your individual bonds and bond-like instruments is only a temporary, paper loss because the face value of your investment is guaranteed, and your income return is not affected, assuming there have been no defaults. And what if the Fed does mistime its moves and the stock market suffers an even bigger correction? Well, if you’re an income investor with a higher risk tolerance, that could create a great buying opportunity to increase the income and growth potential of your stock dividend portfolio. Either way, with so much uncertainty brewing, right now is a perfect time to reassess your risk tolerance and your allocation with the help of an income specialist.
Investment Advisory Services offered through Sound Income Strategies, LLC, an SEC Registered Investment Advisory Firm. Arbor Financial Services of Florida, Inc. and Sound Income Strategies, LLC are not associated entities. Arbor Financial Services of Florida, Inc. is a franchisee of the Retirement Income Store. The Retirement Income Store and Sound Income Strategies LLC are associated entities.