Balance and Objectivity
Without question, 2022 has been a challenging year for the psyche of investors. This year's quick launch in US treasury interest rates introduced pressure on financial markets with incredible speed. For example, one of the most commonly watched rates, the 10-year Treasury yield, closed at 4.2% at one point in mid-October. That came after a historic low of 0.6% registered back in the days of the pandemic. Thankfully, the same rate has since retreated well below 4.0%, a welcomed change in events that have re-benefited bond valuations and other risk-based assets, such as stocks.
Risk-free interest rates matter, and equity prices have risen as long-term risk-free rates have declined as of late. US Treasury bonds are said to be risk-free because they offer an implicit guarantee that the US government won't default on its interest or principal obligations. However, the government's rate doesn't protect against losses caused by inflation. To remove inflation risks, investors must turn to inflation-protected government bonds. But returning to the main point, stocks have recouped some prior losses since hitting bottom last October on peak interest rates. These turns can happen fast and are difficult to predict in advance. This is one of the key reasons why the basic principle of diversification is so important for investors.
Even though November was a moment of relief for investors, giving them a breath of fresh air, investors still can't count their chickens before they hatch. Of course, plenty of sustained headwinds remain on the horizon that require some ironing out over the next few years. For one, the global economy must work down inflation rates and use monetary tightening to regain a sense of balance and stability. Moreover, Russian occupation in Europe and China's heavy hand over its citizenry and share of production puts individual freedoms in jeopardy. A resolution in those two areas could go a long way. Lastly, the US dollar's strength could lead to further international volatility because of how global commodities and many foreign debts are denominated in US dollars. In other words, when the Federal Reserve decides to alter the path of interest rates, its actions have an incredible global reach. Although it's not an exhaustive list, the market watches these factors with an unforgiving eye, keeping the price of uncertainty high as things evolve.
Many investors seem to believe that a recession is imminent, and they may be right, given that several factors might indicate one, such as today's deeply inverted yield curve. Specifically, long-term rates trade below short-term rates in many parts of the curve. In addition, survey data on manufacturing and services that tend to measure economic activity have started to contract as of late. Despite what the consensus may indicate, there are many reasons why economic activity may remain durable in the US. One reason is consumers seem resilient based on recent rounds of wage data, affording them the ability to spend. In addition, household balance sheets still look strong despite what some might think about the recent uptick in the use of revolving credit. Moreover, corporate balance sheets locked in low borrowing costs for a while when interest rates were at all-time lows. Firms that are well capitalized before a rough patch probably possess a competitive advantage to weather a storm. Finally, the collective wisdom of the stock market doesn't appear to support a full-blown recession. For example, stock market earnings are expected to grow into the next year, as they have done this year. However, all these things can change quickly, which is another reason why a diversified investment approach can lead the way when all is said and done.
