The Dow (-1.7%), NASDAQ (-4.9%) and S&P 500 (-2.4%) all fell sharply last week, with the greatest losses occurring on Thursday. Taxable bonds were down about 0.7% and tax-free municipal (muni) bonds were down about 1.5%, so there was effectively no place to hide in a well-diversified portfolio. For the month of February, the market’s sharp declines in the final two weeks were less than the gains from the first two weeks, so stocks were still able to be positive for the month. However, the same cannot be said about bonds. Taxable bonds were down every week during the month, demonstrating losses about 1.5%, extending their YTD losses to about 2% to 3%. Meanwhile, tax free muni bonds have been positive each week since almost October, but their sharp (2% - 3%) losses in the final two weeks of February have caused them to fall into negative territory for the year.
To quote the legendary hall of fame football coach Vince Lombardi, “What the hell is going on out there?” On the surface, it’s pretty simple. The yields on 10-year Treasury bonds have been rising from their historical lows in August, and exhibited a rapid increase the past two weeks. So what, right? Well, don’t undermine the importance of that, because it has been said among the investing experts that the bond market usually tells the story, so here it is. The rise in yields are an indicator of one or a combination of three things – 1) The Fed is poised to raise interest rates 2) The economy is poised to have above trend growth and/or 3) Inflation is expected to rise. Surprisingly, the Fed is NOT poised to raise interest rates any time soon, but the last two points are related, and expected, which has caused interest rates to spike in the last couple weeks. Let’s put this into perspective – the interest rates are basically where they were immediately before COVID hit one year ago. So, as a result of the anticipated stimulus package (which is expected to propel the economy) and the expected above average economic growth for 2021 and 2022, there is concern of inflation. I’m OK with minor inflation if it’s the result of strong economic growth, so we should all be delighted by that.
Pundits believe that the interest rates will continue to remain volatile for the next few months, which could continue to provide more pressure on bonds. That said, it would be important to differentiate taxable bonds from the tax-free muni counterparts, as the latter are expected to have tailwinds over the next year as the stimulus packages and expected tax rate increases will provide a strong case for munis to rally once the interest rates settle down. After long deliberation but in an attempt to act swiftly, we made changes to the portfolio models on Friday. In doing so, we pared back on our exposure to taxable bonds, and slightly increased our exposure to stocks, which are expected to have strong earnings growth over the next couple years. Further, we added to the asset classes that exhibited the greatest drop in the last week. Buy low, sell high, right?