For those of you that are familiar with this classic Dylan folk song, the title is particularly pertinent to the economy, the capital markets, and to our active approach to asset allocation. In fact, we think we’re currently in the midst of distinct secular economic shifts. Some of these may render passive allocation strategies that are based on historical performance less effective than they may have been in the past.

In this piece I’ll walk through a brief overview of a few of the changing factors we see impacting our investment outlook and offer some perspectives.  

Generational Change in the Direction of Interest Rates

Since the early 2000s, many investors have believed that interest rates “had to” move higher. I recall in about 2003 or so, when the 10-year Treasury note was yielding about 4%1 hearing from investors that rates couldn’t go lower. The desire for higher bond rates has been in place for a couple decades by my estimation.

But long before that, since the very early 1980s, interest rates experienced a rather steady decline. At certain points in 1981, investors could purchase 10-to-30-year U.S. Treasury bonds at yields of over 15%1. In today’s environment the idea of a (presumably) risk-free investment with over a 15% annual return seems absurd. But, at the time the global economy was in deep recession, and fear took hold of the capital markets. Many investors chose not to take that deal, and rates on the 10-year U.S. Treasury Note remained above 10% for several more years1.

As most investors know, declining interest rates typically result in higher bond prices. Until recently we enjoyed a four-decade-plus bull market in bonds. Unfortunately, just as trees don’t grow to the sky, there is a point of termination when interest rates approach zero, (or actually go negative as we have seen in other countries) and the bond bull market ends. As the direction of rates has turned in the last 18 months, we’ve seen that bull market disappear. In fact, the 2022 calendar year return on the Bloomberg US Aggregate Bond Index was the worst annual return seen in the history of the index2.

Despite the difficult year in 2022, the good news is that we now have what many investors have been desiring for years – higher bond rates. At the time of this writing, the yield on a 10-year Treasury Note is near 4%, compared with a yield of less than 0.6% just a couple of years ago3. We can now look to the bond market to capture rates that offer the opportunity for more attractive returns than we have seen in some time.

Fortunately for investors, bonds are usually rather transparent instruments. It is a matter of simple arithmetic to calculate the expected return.  When a bond is purchased, the buyer knows certain facts about the instrument: the maturity date, coupon rate, price of the bond, and its credit rating. Using the first three, we can calculate what the return on the bond will be if held to maturity. Absent a deterioration of the credit rating, or default of the issuer, we have a high degree of confidence that we have a predictable return.   

While we don’t expect the bull market returns in bonds that started in the 1980s to continue, we are pleased that we now have rates that can be captured to provide a predictable return to a portfolio. On a final note to this, we encourage investors that have suffered through the 2022 bond market to remain patient, as bonds moving toward maturity could see a recovery over the coming years of their interim losses.

Prospect For Diminished U.S. Economic Growth

There are basically two ways to increase output of an economy: add workers to the workforce, and/or increase the productivity of the existing workforce. Historically, the U.S. has lead the global economies in terms of labor productivity. “Among major economies and regions, the United States has the highest rate of production of goods and services per hour worked, with only a few small European economies outperforming it. Productivity rates in most parts of the world are well below the US’.4

We think that after years/decades where technology related output growth has fueled GDP growth, there may be some challenges for the U.S. economy going forward. Along with this is the possibility that other economies may have more ‘headroom’ for productivity increases.

Economists have conventionally thought that at a 5.0% rate of unemployment, the supply of workers that can move output meaningfully higher has been extinguished. While I might debate that idea to some extent, the notion that as the unemployment rate goes lower it becomes more difficult to find workers to increase output, is valid. As of this writing, the unemployment rate stands at 3.6%5. Despite recent layoffs, employers in general are still encountering difficulty in filling job openings.

This could, among other factors, create a situation where non-U.S. companies have a growth opportunity, and investments in non-U.S. markets could provide attractive relative growth prospects. In terms of domestic investing, we think this could support a condition where security selection with an eye toward valuation and quality return as driving factors in stock returns.

Inflation

I’m sure it isn’t news to anyone that inflation is a driving theme in the economy and markets today. That said, we recently ended an extended period of tame inflation. In fact, for the 20 years from 2001 through 2020, the average rate of inflation was only 2.06%6. While the Fed is famously referring to their target of 2.0% inflation and is currently taking actions to slow the economy and fight existing inflation, we remain cautious that the future may involve inflation that more resembles the longer term rate of approximately 3% in the U.S. and 5.5% globally.

Given that, and the knowledge that economic growth and inflation are the two primary factors that drive interest/borrowing rates, we think that funding growth could become more challenging for companies. We think that the days of borrowing with minimal debt expense to fund growth and/or buy back equity are largely gone. This again pushes us toward a strategy that emphasizes reasonable valuation and quality over growth at the expense of profitability and balance sheet strength.

Conclusion

While we think these shifts in the economy may present challenges to companies that relied on cheap money and an accommodative policy environment to fuel aggressive growth, they also represent a change that presents opportunity for the investor that maintains a properly balanced portfolio. While U.S. growth stock investments have led the way over about the last 10 – 15 years, we think that performance will once again be generated by other asset classes as we move forward. For investors that have implemented an approach based on past performance, or a passive approach that has either relied on or migrated toward some of the major indices, be conscious that the future may not equal the past.

As always, we encourage our valued clients to avoid the temptation to react to headlines, maintain your appropriate risk-based allocations, and rely on Atlas to help manage your portfolio through the changes that inevitably come in the capital markets.

If you have any questions about this, or other financial matters that you would like to discuss, please feel free to contact your Atlas Wealth Management Advisor. They will be happy to discuss your specific situation with you.

Footnotes and Sources


[1] United States Government Bond 10Y – 2023 Data – 1912-2022 Historical – 2024 Forecast (tradingeconomics.com)
[2] The Worst Bond Year Ever Was 2022 – What Does That Mean For You? (forbes.com)
[3] Resource Center | U.S. Department of the Treasury
[4] US continues to lead global productivity race (conference-board.org)
[5] US Employment Gains Top Estimates; Unemployment Rate Holds at 3.6% – Bloomberg
[6] U.S. Inflation Rate 1960-2023 | MacroTrends

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