Markets are fickle, but the tone has completely changed. The skyrocketing bullish mood just a month ago has given way to heightened uncertainty and cautious restraint.
A big change happened this month. Bonds are underperforming, but they’re becoming more attractive. Stock prices no longer rise straight to the sky. The dollar has strengthened, giving investors new reason to worry about rising oil prices.
There are two well-known causes behind many of these changes: inflation and interest rates. Lurking in the background is an increase in geopolitical risks. The possibility that escalating conflicts in the Middle East and rising oil prices could affect U.S. inflation rose again on Friday, when Israel attacked Iran.
None of this is too alarming for the market at this point. At least not for long-term investors who can handle some disruption. But consider this: In the first three months of 2024, U.S. stocks rose relentlessly and bonds posted modest gains amid expectations for a series of cuts in short-term interest rates controlled by the Federal Reserve. Now, months of high inflation have dashed those hopes, or at least deferred them.
“It is appropriate to allow more time for restrictive policies to work and let the data and the evolving outlook guide us,” Federal Reserve Chairman Jerome H. Powell said Tuesday. Simply put, short-term interest rates can be expected to remain high for months to come, barring an emergency.
At the same time, the market-based interest rates that govern the fixed income world are rising across the board. The 10-year U.S. Treasury benchmark, perhaps the single most important benchmark in the global bond world, has risen 0.7 percentage points since the beginning of the year. This is a significant rise in the robust world of bonds, with yields this week above 4.65%, the highest since November.
Stock prices have fallen, and oil prices have risen as much as 18% this year in the futures market. Brent crude oil, the world benchmark, is hovering around $90 per barrel. Traders expect oil prices to fall over the next year, according to futures markets, but the escalating conflict between Israel and Iran could change that outlook in an instant.
iran and israel
Iran is a major power in the Persian Gulf, and calling the region geopolitically important severely understates that claim. In particular, the Strait of Hormuz between Iran and Oman The U.S. Energy Information Administration says it ranks as “the world’s most important oil chokepoint.” The agency estimates that in 2022, about 21% of the world’s liquid petroleum consumption will come from this oil. If traders start panicking about the vulnerability of oil there, prices will skyrocket.
At $100 a barrel, or worse, $110 or $120, higher oil prices would “impact core inflation, pushing it lower toward the Fed’s target,” according to an analysis by independent research firm Oxford Economics. It could slow down.”
The Persian Gulf is not the only geopolitical hotspot. Recall that Brent crude oil exceeded $120 per barrel in June 2022, early in the Russo-Ukrainian war. That war could disrupt oil supplies again.
For true long-term investors who buy and hold stocks and bonds through low-cost index funds, these changes probably won’t be a big deal. Twenty years from now, it will hardly be remembered.
At least, this is my hope based on history. But if you have a short investment comfort horizon, or just want to know what’s happening to your stock holdings, April starts out as a cruel month, even if it’s too early to say it’s the cruelest. I did.
We cannot know in advance whether we are experiencing a temporary hiatus in the bull market or the beginning of something more significant. But there is little doubt that market momentum is wavering.
bond
Bond yields are significantly higher than they were a few months ago. While this has hurt bond returns this year, it has also made bonds even more attractive when compared to stocks.
“Relatively and historically, bonds are looking pretty good right now,” said Andy Sparks, managing director and head of portfolio management research at financial services firm MSCI. “Of course, we’ve been saying that for a while,” he added ruefully.
Most bond funds made a profit in the first three months of the year, but rising interest rates are now pushing many into the red. The Bloomberg U.S. Aggregate Index and the fund that tracks it, the iShares Core Aggregate U.S. Bond ETF, will fall about 3% in 2024. 20+ Year Treasuries and iShares 20+ Year Treasuries ETFs that track these bonds have fallen 9% this year.
What makes these declines so painful is that they come not long after the huge decline in 2022. The aggregate index returned -13%, and the long-term government bond return was -31%. While returns in 2023 weren’t bad, they didn’t make up for the losses in 2022, and now bond values ​​are falling again.
That’s entirely due to inflation and interest rates. When interest rates rise, bond prices fall. That’s how the mathematics of bonds works.
Despite these setbacks, there is some good news for the bond market.
Bonds have higher yields and provide investors with more income. If interest rates fall from here, bond prices will rise. And on a comparative basis (using metrics like the S&P 500’s earnings yield, which is basically the inverse of the price-to-earnings ratio), the higher the yield, the better the bonds generally look than they have been in years.
Additionally, if more violent wars break out in the Middle East or Eastern Europe, or if stock markets plummet for any number of other reasons, investors looking for a safe place to park their money could be drawn back to U.S. Treasuries. is high. . The increase in demand will likely drive bond prices higher and yields lower, benefiting current bond investors.
However, I would like to add one major caveat. If inflation rises further, interest rates will likely rise as well, causing losses on bonds. That happened in a big way in 2022, but it’s echoing again this month in a much weaker form.
stock
The stock market’s performance through March could only be described as meteoric. So the S&P 500 is still up about 4% in his 2024, and over the past 12 months he’s up 19%. But at the end of March, that figure was 10% for the year and 28% for the 12 months.
For much of this year, enthusiasm for artificial intelligence has fueled a stock rally reminiscent of the dot-com boom of 1998-2000. The initial bull market turned into a bubble and burst. The current slowdown in market momentum could be a good thing if we give new technologies a little time to penetrate the economy, bring productivity gains, and benefit a wide range of companies.
But this year, there are signs that the market may be getting ahead of itself. Consider that until March, nearly 80% of S&P 500 companies had positive earnings for the calendar year. In April, more than 90% of S&P 500 companies fell.
Fossil fuel companies such as ExxonMobil are on the rise due to tensions in the Middle East. For the calendar year, Exxon returned about 20%, including dividends. The oil crisis will hurt most stocks, but it will be a boon for oil companies. This is a reminder of why diversification is beneficial from a purely financial perspective.
Other asset classes are changing in value as well. The dollar, which has been in decline since November until the end of 2023, has been rising recently. The simplest explanation is to compare world interest rates. Swiss banks have already lowered their benchmark interest rates, and the European Central Bank is likely to follow suit. The Bank of Japan raised interest rates for the first time in 17 years in March, but the yen remains weak because interest rates are too low compared to the United States. With the Federal Reserve unlikely to lower short-term interest rates anytime soon, the dollar has soared, giving international travelers more purchasing power but deteriorating the terms of trade for a wide range of U.S. businesses.
What is certain is that broad diversification across asset classes helps stabilize long-term investment returns. Since 2007, world stock markets have risen by 7.4% annually, and the US stock market has risen by 9.8%, MSCI estimates. The return on US Treasuries was 2.5%.
As an investor, I rely on returns like this, mostly holding stocks through low-cost index funds, and holding large amounts of bonds, which can be used over weeks, months, and even years. I try not to pay too much attention to market changes. It’s worked before, and although there are no guarantees, I think it’s likely to work long-term.
