Strategic Investing Can Keep Portfolios Strong Amid Volatile Economy
Weighting of Certain Types of Investments is Key
Protecting your investment portfolio from a volatile economy requires proactive management and strategic weighting of certain types of investments. Acting now can help keep your portfolio afloat and avoid the hollowing out that some investors are experiencing as today’s economic volatility continues.
Understanding how inflation and economic swings affect the stock and bond markets is key to managing your portfolio strategically and controlling what you can control.
After remaining relatively low for the past decade or so, inflation rose sharply last winter — fueled partly by soaring oil prices — and has held steady above 8% throughout the year. Consumers feel it at the gas pump and grocery store, while investors feel it in the markets.
The Federal Reserve has hiked interest rates five times already this year, with expectations of further hikes in the remaining months of 2022. These significant increases in the fed funds rate suggest the FOMC takes seriously widespread criticism that they waited too long to address inflation when it started to climb.
“Our obligation is to use our tools to support the economy, and that’s what we’ll continue to do,” says Federal Reserve Chair Jerome Powell. But if Federal Reserve has only one tool, a hammer – does every problem looks like a nail? Some might say so. Interest rate hikes are Federal Reserve’s way of hitting that nail.
As Federal Reserve pumps the brakes on inflation with interest rate hikes, the equity and fixed income markets respond under pressure. While an interest rate hike typically takes several months to work its way through the system and impact the economy more broadly, the stock market’s response is more immediate. Generally, higher interest rates negatively impact earnings and stock prices, apart from the financial sector. Higher interest rates also tend to depress future discounted valuations.
As a hedge against the impact on the equity market, investors typically seek safety in fixed income assets. But this year, the impact on a portfolio’s fixed income assets will look different. For example, bond fund performance may decrease by double digits for the year, depending on duration and quality. As Federal Reserve eases treasury and corporate bonds off its balance sheet, it will upend the supply in the bond market and make for a unique environment for fixed income buyers.
So, what is typically a safe space for investors will likely show a decrease in value during this environment. Exacerbating the situation is the potential of bond funds resulting in a capital gain distribution at the end of the year, which would be taxable.
All of this may seem odd because the economy does not look unhealthy. Earnings are generally good, consumer sentiment is mixed, but some positive indicators are emerging, and the summer rally in the stock market speaks to that. We still have some volatility ahead of us; September and October are often choppy in the stock market, but November and December are historically good.
We are advising our clients who have IRAs to make contributions now. The discount in the market is hard to ignore and contributing now, rather than at the end of the year, could help capture some of that value.
In equity portfolios, we are overweighting quality. In uncertain times, this provides control over the portfolio’s performance. We are overweighting U.S. stocks over international companies, as well as larger companies to get some stability in the blue chip dividend-paying space. Being defensive with dividends is an important control strategy. Specific sectors that an investor may consider overweighting right now are healthcare, energy and technology.
On the fixed income side, we have had success for our clients buying individual fixed income securities rather than bond funds. Short-term Treasury yield above 4% is hard to ignore. Though investing in bond funds has become conventional wisdom on Wall Street, buying individual bonds at this time provides stability and control not present with a bond fund.
With an individual bond, you buy an instrument with a set value on a set maturity date. So, you know you will have an investment worth a specific amount when that date arrives, and you will collect income in the meantime. The volatility of a bond fund — even a well-balanced one — is no longer a factor. It is one way to level out the pieces of a portfolio that investors rely on as a safe space.
It is easy to become discouraged with your investment portfolio during volatile economic times, especially if you are close to retirement or already retired and relying on your investments for income.
Stay the Course
But there is cause for optimism. One particular investor in his 80s has an asset allocation of nearly 100% in U.S. equities — a higher-risk allocation more typical of an investor in their 40s. When asked his rationale, the investor said to look at any 10-year period in the stock market and see what it does. “What’s the stock market trend over the last 100 years,” he asked. The stock market has historically risen over time. By toughing out the rocky periods, this investor reasoned, he was building value that would pass to his heirs.