Ladies and gentlemen, the weekend! In this space each week, Greg and I share some of our favorite articles, notes, and graphics from the past week along with our commentary. Please feel free to provide feedback and forward along to others if you enjoy. We appreciate you taking the time to read. 

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Bond Market Update: Navigating a Rising-Rate Environment

“When investing in high-quality bonds, yield is typically the major component of total return. One reason why bond market returns were so negative as rates rose in 2022 was the starting point of yields. Since yields were near historic lows in 2020–21, there was little cushion to absorb the impact of rising rates. Now that yields have moved [4-5%] higher across the curve, today’s starting yields offer much better prospects for total returns going forward—and can also provide a much bigger cushion to absorb a potential continued increase in yields…

Earlier this year, the market’s consensus view seemed to point to a ‘pause’ in rate hikes by the U.S. Federal Reserve (Fed), as inflation readings were coming under control, and predictions of a ‘hard landing’ for the U.S. economy were common. The U.S. Treasury yield curve (the 10-year yield minus the two-year yield, also known as the 2s/10s curve) hit a peak inversion of -108 basis points (bps) in early July, and markets were pricing in Fed rate cuts in the near future. But we all know how difficult it is to predict what may happen with interest rates.

Recent data have pointed to a resilient economy; talk of a hard landing has diminished; and ‘higher for longer’ seems to be the new consensus for Fed’s rate regime. Markets have reacted by pushing Treasury yields sharply higher, with both the two-year and 10-year Treasury yields increasing by more than 125 bps off their lows of the year (see upper panel of Figure 1). The curve has begun to normalize in a ‘bear steepener’ with the 10-year yield moving much higher, and with the 2/10 curve steepening from the -108-bps peak inversion in July mentioned earlier to -30 bps as of October 6, as seen in the lower panel of Figure 1.

How has that translated to bond market performance? The rapid rise in yields has once again led to sharply negative returns in longer-duration government-related securities, as shown in Figure 2. Treasuries were negative across the curve in the second quarter, yet the two-year note held up better given its lower duration. During the third quarter, as the curve steepened, the two-year was able to generate positive returns despite a more than 5% loss in the 10-year note. Stringing these periods together and adding on the tumultuous first week of the new quarter, you can see the 10-year Treasury has suffered a loss of -8.5% since the end of the first quarter, while two-year Treasuries experienced only mild losses.”

Over the past couple of weeks, we’ve highlighted some of the skewed performance in bond markets. Longer duration bonds have continued to feel the pain as the “higher-for-longer” bond market repricing pushes up interest rates from 5 years and out. 

Fortunately, we are about to the point where coupon rates are high enough to absorb bond principal losses from interest rates moving even higher. However, that doesn't necessitate increasing portfolio duration. Shorter duration bonds, whether government, investment grade credit, or other, still present some very attractive risk/return opportunities.

3rd Quarter 2023 Earnings: Here today, what about tomorrow?

“At the start of the year, investors and economists were confident that 2023 would be a challenging year for the economy, markets and corporate profits. In the event, however, growth has been better than expected, equity markets are higher and earnings have surprised to the upside. While many have expressed concern about the nature of the rally this year only being led by a few stocks, healthy earnings growth has prevented the broader market from melting down; however, as interest rates have marched higher in recent weeks some signs of weakness have started to materialize.

Higher rates should weigh on valuations, leaving earnings as the primary driver of return. With 238 companies reporting (58.8% of market capitalization), our current estimate for 3Q23 S&P 500 operating earnings per share in $55.43. If realized, this would represent year-over-year (y/y) earnings growth of 10.1%, and quarter-over-quarter (q/q) growth of 1.1%. Thus far, an impressive 71% of companies have beaten earnings estimates while only 48% of companies have beaten revenue estimates as inflation continues to slow. However, both earnings and revenue surprises have been positive, with earnings beating by an average of more than 7%. Meanwhile, and arguably most importantly, profit margins have only declined slightly, with our current estimate tracking 11.8% versus 11.9% in 1Q23.

It seems reasonable to expect that this trend will continue through the end of the year, but the combination of slower nominal growth and margin pressure should lead earnings growth to slow going forward. With the recession question still unanswered, investors would be well-served by listening to management commentaries and thinking about the potential distribution of outcomes in 2024. Markets have not necessarily liked the messages being sent; companies that have beaten earnings and revenues have seen a very modest increase in their stock price, whereas those companies that have missed have been punished severely.”

Corporate earnings season kicked into a higher gear this week with many of the mega-cap technology and consumer discretionary companies reporting. Earnings and revenue beats are in line with historical bullish sessions, but forward guidance has been somewhat weak.

With interest rates at current levels, corporate earnings will need to grow to support stock market returns. It will be very difficult for stock price multiples to expand with U.S. Treasuries and other more stable investments paying more than 5%.

5 Common Failures in Personal Finance

“Inspired by this line of thinking, I wanted to examine…

• What are the biggest sources of personal finance failure?
• What should you be doing in your life to avoid such failures? What questions can you ask right now? How can you break the chain? 

1) Failures of Measurement

As Peter Drucker says, 'You can’t manage what you don’t measure.' Measuring your personal finances is fundamental to success…

Specifically, I suggest measuring 'the big four:' 

• Income and expenses (i.e. via a budget, updated monthly)
• Assets and liabilities (i.e. via a net worth statement, updated quarterly)...

2) Failures of Understanding

It’s hard to know everything. Thus, we all suffer failures of understanding. But as Mark Twain said, 'It ain’t what you don’t know that gets you into trouble. It’s what you know that just ain’t so.'

Example: an acquaintance of mine is positive that his annuity is a great decision for him. [Narrator: 'It’s not']…

The question to ask is: 'What is the world actually like? How might my assumptions be wrong?'

3) Failures of Planning

Some aspects of the future are knowable. We know we’ll grow older. We know many aspects of personal finance change as we age. We know we should plan accordingly.

But we don’t always do so, leading to failures of planning.

As an example, required minimum distributions (RMDs) are a known quantity in retirement planning. RMDs are mandatory withdrawals that individuals with certain tax-advantaged retirement accounts, like Traditional IRAs and 401(k)s, must make once they reach a specific age, typically starting at 72. 

The Federal government wants its tax money. RMDs ensure that happens. 

What happens if a retiree already has a healthy retirement income? Can they postpone the RMD? Nope! Their RMD occurs anyway, incurring taxes at a high marginal tax rate. Ouch. 

Good tax planning mitigates this problem. 

The question to ask is, 'Based on what I know today, what should I be concerned about in the next 1, 5, 10+ years?'

4) Failures of Imagination

Failures of planning deal with known facts. Failures of imagination deal with unknown facts. The classic saying is 'You don’t know what you don’t know.' It’s hard to imagine the unknown.

Nobody knows how the investment markets will perform over the next 1, 5, or 10 years. If anyone knew for sure, they’d be able to leverage that knowledge into billions of dollars. This fact – that market performance is unknown – is the precise risk that creates investment reward. Without the unknown, investing would be fruitless…

The question to ask is: 'What’s possible?! What could possibly go wrong?'

5) Failures of Risk Management

Our finances can be a risky business. That’s okay, as long as you understand the risks.

Planning and imagination typically do a good job of identifying risks. The next important step is to quantify those risks, and then mitigate them or protect against them. That’s risk management.”

I enjoyed this article, though wouldn't particularly call these failures. They are more like opportunities or weaknesses that most of us have. A good financial advisor can help you think through these and hopefully shore them up.

On Thursday, the Bureau of Economic Analysis reported that the U.S. economy grew by 4.9% annualized in the 3^rd quarter, beating the consensus forecast of 4.5%. That was the best quarterly growth rate since the 4^th quarter of 2021. If we exclude the whipsaw of the pandemic recession and recovery in 2020-21, it’s the best quarterly growth rate since the 3^rd quarter of 2014.

Consumer spending drove growth by expanding at a 4% annualized rate, while government spending, business investment, and inventories were all positive contributors.

Eventually, the pessimism spewing from economists will be correct (see the old broken watch adage); however, the can keeps getting kicked down the road.

Thanks for reading. Have a great weekend!

RBG Wealth Advisors LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.