3rd Quarter 2023.  

Market Review

Performance Driver Review

Market Perspectives
With summer in the rearview mirror in Wisconsin, locals can assume the season of road construction will disappear along with it. Nonetheless, all can recall buzzing down the interstate and peeking over at that road worker high atop a steamroller, pressing down the fresh asphalt with ease. As an onlooker, the last place one would want to be standing is right in front of that 10-ton steamroller.

In investing, when someone is making a trade that only slightly increases returns while taking on substantial risk of loss, they are often said to be “picking up pennies in front of a steamroller.” While a person could likely pick up several pennies in front of a slow-moving steamroller before any damage occurred, when damage did set it in, it would likely be catastrophic.

While this metaphor is often used in derivative investing, WoodTrust finds it quite applicable to the short-mindedness of investors with a heavy overweight to cash in their portfolios. While a strategic cash position is an important part of portfolio construction, many investors have moved significant portions of their portfolios to cash. With banks championing high yield savings accounts and CDs; money market funds shouting about attractive, low risk returns; and several financial experts on record stating how much cash can return “with no interest rate risk,” investors are left wondering “why not keep all my money in cash and earn 5% per year with no capital at risk and no interest rate risk?” The answer is a less talked about risk, albeit an important one. It’s what makes holding mostly cash similar to picking up pennies in front of a steamroller… reinvestment risk.

Reinvestment Risk
Interest rate risk is the volatility in an investor’s portfolio that results from changes in market rates. This risk is measured by a portfolio’s “duration,” or the weighted average amount of time it takes investors to receive their entitled cash flows from the investments they own. Typically, investments with short-term maturity dates that are considered “cash” have very low duration and, therefore, very little interest rate risk.

At the opposite end of the spectrum is reinvestment risk. Reinvestment risk is the risk that the future yields available when an investor’s portfolio matures will be different than current yields. This is of heightened concern during economically sensitive periods as both long and short yields can move very quickly. That yield move is the steamroller, and the “pennies” are those few extra dollars’ worth of return over the next handful of months that investors are focused on while giving up the opportunity to lock in yields at 15-year highs for several years into the future.

How long is longer?
As noted, this is an economically sensitive period and both short and long yields can move dramatically over short time periods due to action by markets and the Federal Reserve. The Fed has asserted that despite economic sensitivity, it intends to keep rates “higher for longer.” Many have found solace in this comment when it comes to retaining their high allocations to cash. Unfortunately, while higher for longer is plausible, in practice it has been difficult. During the last three recessions, once the economic pain is felt, the Fed has been forced to cuts rates swiftly and sizably with the majority of rate cuts happening over just a few quarters at most.¹ Aggressive cutting would likely lead to lower yields.

 By the Numbers
“But surely the best thing an investor can have if the economy enters a recession is cash!” Well, according to the numbers, not necessarily… During the last 40 years of rate hiking cycles, whether they ended in a recession or a “soft landing,” cash underperformed core bonds in the 12 months following peak cash yields every time and even underperformed stocks all but once.²

This is not to say history always repeats itself. The last few years have been peculiar to say the least with several “never before seen” actions and a host of record setting policy decisions. Things can always be different. However, ignoring the lessons from the past and being swayed from one’s investment discipline by the “riskless” red herring of the inverted yield curve clearly comes with a cost.

Something for Your Trouble
“But what if it is different?” The bond market investors of 2022 are understandably sick and tired of “different.” “Different” in 2022 meant the fastest slew of rate hikes markets had seen in decades resulting in atrocious bond market performance. After investing through this period, it’s reasonable to fear what further hikes or even “higher for longer” could do to a bond portfolio. However, the difference between where investors stand now and where they stood heading into 2022 is the yield buffer that the bond markets have granted them for their troubled portfolio performance. As of the end of 3Q23, the yield on the 5Y Treasury sat at 4.61% vs a measly 1.26% at the end of 4Q21. This higher yield means that even if rates move up another 1%, an investor holding that 5Y Treasury would still be nearly break-even one year from now (-0.10%). An investor holding that bond with a 1% rate increase at 4Q21 levels would have experienced a -2.74% return over a one-year period. This should give bond investors comfort when lengthening their portfolios.³

In Summary
Investing starts with an understanding of goals and objectives. Most goals and objectives require a strategic cash position in a portfolio, but holding significant excess cash at the expense of core fixed income can have long-lasting implications. It remains an excellent time to create portfolios that generate durable income for several years to come while mitigating the risk of the metaphorical steamroller. As always, we thank you for your trust and look forward to our meetings with you in the near future.

 ¹Dot Com cutting cycle: ~86% of cuts over 12-month period, GFC cutting cycle: 65% of cuts over 8-month period, Covid cutting cycle: 100% of cuts over 9-month period
²Source: JPMorgan Guide to the Markets – 4Q 2023, “CD rates and other investment opportunities”; Cash = 6-month CDs, Core Bonds = Bloomberg U.S. Agg, and Stocks = S&P 500
³Total return figures, assumes a parallel shift in the yield curve