Q4 2022

January 10, 2023

The final quarter of 2022 mirrored what we saw throughout the year. The stock markets rallied early in the quarter only to sell off and close at- or near- lows by the quarter’s end. Markets continue to be volatile.

I spent considerable time in my last quarterly letter describing the root causes of the sell-off. I’d ask you to read that letter (it’s posted on our website at www.nicolletinvest.com/quarterly-letters) if you’re interested. What I wrote describes the 4th quarter as well as it did the 3rd.

So, what’s new?

Our growing confidence is that the Federal Reserve is committed to snuffing out inflation. The Fed raised interest rates again last quarter and they appear resolved to continue doing so until inflation is under control. We’ve worried they might revert to past policy mistakes; it now seems less likely.

That’s good news for the long-term health of the markets.

How is this influencing our decisions?

If we believe the Fed is going to stick to their guns and tame inflation, we need to be prepared in our bond portfolio management. There will be a time when we may want to start extending the maturities of the bonds we buy.

As you know, we have kept bond investments relatively short- to intermediate-term. It’s been our strategy because interest rates were so low. We felt there was no good reason to lock-in low rates buying long-term bonds.

Today, by historic standards, interest rates are still low, but they have moved up significantly. What we’ve seen over the past year is: 1-year Treasury bill rates rise from 0% to 4.5%, 5-year corporate bond rates increase from just over 1% to over 5%, and 10-year corporate bond rates go from 2% to almost 6%.

This type of move requires careful consideration. How should we respond?

Before I tackle that let’s review how we manage our bond portfolios.

When you hired us, we asked you to go through an extensive examination of your finances. There are several reasons for that effort, but one critical reason is we learn a lot about your future cash-flows. Our work gives us reasoned projections for what you will need from each of your accounts and when.

That, in turn, allows us to make recommendations for your investment allocations to cash, bonds, and stocks. For my purpose here, let’s focus on our recommended allocation to bonds.

A major driver behind our bond investment recommendations is funding your expected withdrawals. We want the amount you hold in bonds to, at a minimum, cover many years of projected withdrawals.

That withdrawal information becomes critical to building your bond portfolio. Nicollet’s Bond Portfolio Manager, Tim Fahey, needs to know this information before he can start buying bonds in your account(s).

We want the combination of interest income paid by your bonds, plus the maturity value of the bonds (the principal) to cover your withdrawals for many years.

Tim’s job is far more complex than most understand because he needs to do this for every account (not just “client”, but “account”) that has an allocation to bonds. Over the years, we ‘ve developed systems that help him, but it’s still a very complex task.

Adding to the complexity is the fact that all forecasts are subject to errors. It’s the nature of forecasting. These variances have been less an issue when we are intentionally buying bonds with short- to intermediate-term maturities. If the bond portfolio’s duration is less than the liabilities it’s funding, it will be generating more cash-inflow each year than needed for withdrawals. Because of that, when unexpected withdrawal requests were made, the cash tended to be there.

Now, with rates rising, we must consider when to start buying some longer maturity bonds. This decision will always be constrained by projected account withdrawals, as we will never invest money that’s needed in 3-years, in a 10-year bond.

However, if we can lock-in money needed in 7-years, in a 7-year bond, when do we start? Part of the decision is based whether we think the Fed will remain diligent in fighting inflation. Part of the decision is based on whether we think the current interest rate paid is sufficient. And part of the decision is based on how certain we are that the account withdrawal estimates are correct.

For the past month, we’ve undertaken an extensive review of our models for every client. From that work we’ve identified those that we want to update. This is all being done so we are prepared to start buying some longer maturity bonds and respond to rising rates.

On the stock market side of things, our growing confidence in the resolve of the Fed is improving our longer-term outlook for stocks. The economy is still working through the effects of rising interest rates, falling confidence, and some inventory issues. We still have not seen the full impact of these forces on company earnings.

We’re not likely to see stock markets firm up until there is certainty that the Fed is going to pause (stop raising interest rates) and report inflation moderates. Hopefully, that’s a narrative we hear in 2023.

My very best to you and your family in the New Year!

Mark Hoonsbeen, CFA
Principal
Nicollet Investment Management
800 North Washington Ave, Suite 150 Minneapolis, MN 55401
Phone: 612-915-3033
Email: markh@nicolletinvest.com