Fourth Quarter 2021

It was another strong year for the stock market as the economy continued to rebound from the Covid shutdown that occurred in 2020.  However, due to logistics, snarled supply chains, and staffing challenges, demand has exceeded supply for many products and produced inflation numbers we have not seen for quite some time.  We believe these supply issues will persist into 2022, extending the volatility we have recently experienced in the equity markets.

As we look towards 2022, we thought we would shift the focus of our year-end letter to discuss an area that has not received much press in the last few years.  Specifically, cash and the struggles to generate meaningful income and yield. 

As we look to reallocate funds after several strong years in the stock market, we expect to continue to generate and maintain larger cash balances periodically throughout 2022.  When discussing with clients a potential stock sale, we are often asked: “What are you going to do with the money after the sale?”  It’s an excellent question.  As investors, we want to have our money “invested” at all times.  The reality is that we often need to be patient and hold cash to be ready for the next investment opportunity when it presents itself.  This is why cash is an important part of a portfolio and the most difficult asset to manage.  For stock accounts, cash represents “ammunition” to invest in solid companies when market prices wane.  For balanced accounts, cash can be reallocated into stocks or towards bonds to generate income and reduce the volatility from exposure to stocks.  In either case, cash is an important part of any investment strategy.  One needs to determine when to hold it and when to deploy it.  We remain vigilant on seizing those opportunities.

For the portion of a portfolio that is purely targeted for fixed income, the current interest rate environment has limited our options.  For several years now, we have communicated in our quarterly letters how interest rates are near zero.  As percentages can be somewhat difficult to conceptualize, we want to highlight what that means in dollar terms. 

Cash is an important part of any investment strategy. One needs to determine when to hold it and when to deploy it.

Let’s say we have $50,000 in cash and want to invest in a high-quality, liquid security for 6 months.  As an example, the current interest rate on a 6-month FDIC insured CD is approximately 0.25%.  That would translate to $62.50 of income for the 6 months.  A 6-month U.S. Treasury bill yields even less at around 0.15%.  This would produce $37.50 in income for 6 months.  Even if you bought a 2-year U.S. Treasury note, your rate increases to only 0.70% – generating $175 every six months.

And longer-term bonds don’t provide much better of an opportunity.  The 10-year Treasury note is currently trading around 1.5% while high quality corporate bonds with the same maturity are trading slightly above 2%.  Investing in these types of bonds would lock in returns that are below the long-term inflation rate and significantly below current inflation rates.  A negative real rate, and our increasing confidence that the Fed will raise rates in 2022, is why we do not support buying long-term bonds at this point in time.

Here is a chart with the median yield for some quality fixed income options.  It highlights the income per year on $50,000 invested:

 

                    1 Year

                    2 Year

                    5 Year

 

 

     Rate

    Annual                Income

 

     Rate

    Annual                Income

 

    Rate

     Annual                 Income

FDIC Insured CD

     0.30%

      $150

    0.60%

      $300

    0.80%

       $400

U.S. Gov’t Bond

     0.34%

      $170

    0.70%

      $350

    0.95%

       $475

Corporate (A Rated)

     0.32%

      $160

    0.86%

      $430

    1.60%

       $800

Source: Fidelity.com.  The rate information is obtained from third-party sources believed to be reliable but not guaranteed.

As you can see, there is minimal income available from high-quality fixed income options.  Because rates are so low, investors have been encouraged to take more risk.  We urge you not to fall into this trap.  One should be leery of any investment that claims returns of 4% or 5% with “little risk”.  In these cases, there are more substantial risks that need to be identified.  Although people view bonds as “less risky”, an investor can lose substantial amounts of money in fixed income especially in a rising interest rate environment.  Therefore, by holding cash, the opportunity cost is very low, if nonexistent.

We have written for quite some time that zero interest rates would be with us for the foreseeable future.  However, for the first time in many years, that may be changing.  Recent inflation readings have put the government and the Federal Reserve on notice.  Inflation is a tax on everyone through higher prices and is something that is closely watched by the Fed.  To combat the rise in inflation, the Fed is now aggressively reducing their bond purchasing program.  Moreover, the market is now signaling three interest rate hikes in 2022 with additional hikes expected in 2023 and 2024.  Our strategy would be to hold cash or short-term fixed income and look to take advantage of higher rates as the Fed addresses inflation concerns over the coming years.  

Connect your finances to what matters most

This article can provide only a general understanding of sometimes difficult financial concepts. For for a more thorough explanation, or if you have questions about your own portfolio, please feel free to reach out to us here at McRae at (973) 387-1080.