November 2017 Investment Commentary

November 2017 Investment Commentary
  • Time to give thanks! Steady global growth, improving labor situation, and low volatility are all something to be grateful for.
  • As high yield bonds briefly sold off to start the month, in the past this has been viewed as an early warning sign for equities, however it doesn’t seem to be the case this time.
  • With a new Chair coming on board next year, it looks like more of the same regarding future monetary policy.
  • Excess debt issuance in emerging markets has caught our interest, but fundamentals overwhelmingly remain positive.

I remember growing up in grade school being given an assignment this time of year in which we would write about the numerous things that we are thankful for…  In the spirit of my youth, I thought I would use this opportunity to revisit this age-old exercise.  As a portfolio manager and market practitioner, I have no shortage of things to be thankful for, all of which support a healthy market and growing economy.  I am thankful for the lack of volatility, which as we all know will return at some point… with a vengeance… but in the meantime, we can all be appreciative of the slow and steady upward grind in the equity markets.  Volatility may be good for brokerage firms and high-frequency traders, but not for long term strategic investors.  I am also thankful for the transparency that the Federal Reserve and central banks across the globe have provided.  Yes, we are in a rising rate environment here in the U.S., but the Fed has been crystal clear regarding their shift from accommodative to restrictive policy.  Because of their open and forward-looking guidance, the markets have absorbed the news and adjusted to the new reality without getting rattled.  Having learned from the “Taper Tantrum” in 2013 when the Fed caught investors off guard with unexpected talks of rate hikes, since then the Fed has largely spoken and acted in line with expectations, which has resulted in the low volatility cited above.  Finally, I am most thankful for this period of synchronized global growth that we are currently experiencing.  Fueled by low interest rates and accommodative policies, corporate earnings across the globe are on the rise, which has led to GDP expansion across both developed and emerging economies.  Here in the U.S. the technology sector, led by the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) has led the way as the S&P 500 Total Return Index has now increased for 12 consecutive months.

From a macroeconomic perspective, we still find ample reasons to be optimistic that the market and the economy can continue to grow.  The Conference Board’s Leading Economic Index (LEI) did decline in September for the first time in a year, but it did so off of it’s all-time high.   The index has 10 components that in aggregate help signal and identify peaks and troughs in the business cycle.  The small decline in September was likely due to the temporary impact of the recent hurricanes, according to  Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. He also quoted that “The source of weakness was concentrated in labor markets and residential construction, while the majority of the LEI components continued to contribute positively.” Judging by the chart above, it is clear that the trend in the Leading Economic Index is still positive, which bodes well for future growth in the coming months.  Prior to the past two recessions, the LEI peaked 4 and 19 months (respectively) prior to the peak in the S&P 500.

 High Yield Bonds have been selling off… Precursor or Isolated Event?

While most asset classes have continued to post positive returns, so far November has been a rough month for high yield bonds.  Using the iShares iBoxx High Yield ETF as a proxy (ticker HYG), the index is down almost 2%, and is trading well below its 50-day and 200-day moving average.  The high yield asset class also experienced a notable correction in March, and again in August, but both times rebounded once it traded near its 200-day average.  This could be concerning, given the fact that high yield bonds are trading at historically tight spreads, meaning investors aren’t being adequately rewarded for taking on additional risk, and that if spreads continue to widen the prices will fall further.  It also could be alarming, as often times the high yield sector is considered a leading indicator of the stock market, so if problems arise in the high yield market this could make its way into broader equities as well.

So what has been pushing high yield bonds lower?  It appears that the losses in high yield bonds have been mostly attributed to a few particular companies, most notably in the telecom and health care industries, due to a few failed merger talks and earnings misses.  In addition, it was recently announced that the Republican’s tax-reform plan would cap interest deductions for companies with debt higher than 30% of earnings before interest, taxes, depreciations, and amortization.  While this change won’t affect a significant portion of the market, it will likely impact those higher indebted corporations.  On a positive note, if the brief selloff can be explained by these few factors, as compared to a deterioration of credit in general, it is less likely that this brief selloff will be a leading indicator of more significant losses in the equity markets.  In fact, as of the time of this writing, high yield bonds have already rallied off their lows, so it will be interesting to see if the asset class can rebound even further as we enter the holiday season.

Probably a more significant concern, as we have noted several times in the past, is the spread between longer dated and shorter dated bonds which has been tightening for several months now.  The spread between the 10-year treasury and 2-year treasury is now just 0.72%, down from 1.0% in July and 1.25% at the start of the year.  Over the long run, longer dated bonds should warrant additional yield to compensate investors for investing over longer periods of time.  When longer yields decrease to levels at or below short-term bonds, it implies a lack of risk appetite amongst investors.  An inverted yield curve is also bad for banks and the financial industry, as this diminishes the profitability of borrowing short term and lending long term.  Each of the past 7 recessions going back over 50 years have been preceded by an inverted yield curve, although there have been instances where the yield curve inverted and recessions either did not occur or occurred years after.  Regardless, it is prudent to take notice when the yield curve flattens, as this usually foretells a shift in risk behavior and it may lead us to adjust our asset allocation as the spread gets closer to zero.

Trump’s Fed Chair Selection Should Bring Continuity

As many had predicted in the days leading up to the decision, President Trump selected Fed Governor Jerome Powell to succeed Janet Yellen as the next Fed Chair.  This selection should bring a good deal of continuity regarding monetary policy, while Powell has also been more supportive of financial deregulation in comparison to Yellen.  A December rate hike is still widely expected, with the futures market assigning a 96.7% probability of hiking to 1.25-1.50%, according to the CME Group.  With unemployment at decade-lows, inflation comfortably below target, the Fed has little reason to not proceed with their third rate increase this year.  Regarding future rate hikes into 2018 and beyond, the Fed’s “dot-plot” shows that the median expectation is for 3 rate hikes next year, however the futures market is currently only showing a 12% chance of that happening by year end.

Also not expected to change, is the Fed’s plan to slowly decrease the size of their balance sheet, currently at around $4.5 trillion.  In October they allowed $10 billion in treasuries and mortgage-backed securities to run off, and this amount is expected to increase to $50 billion in the coming months.  On a relative basis, this shouldn’t have a huge impact on the bond market, especially since the central banks in Europe, Japan, and elsewhere are still months-to-years away from quantitative tightening.

Things could change though if and when all central banks start tightening, however only time will tell how markets will react.

Early Signs of Excess Debt Issuance in Emerging Economies

Despite all of the positive news, we do still have our apprehensions.  According to research by Bank of America/Merrill Lynch, issuance of securitized assets rose by 61% in China during the first half of 2017.  This may be concerning, as the implosion of asset-backed securities was a major factor which led to the 2008 financial crisis here in the U.S. While these securitized products are a relatively new phenomenon in China, the fact that issuance is accelerating at a record pace is eerily reminiscent of the exuberance which occurred in the U.S. during the mid-2000’s.  In addition, the Financial Times recently reported that junk-rated emerging market debt issuance is up 50% year-over-year to the highest total on record.  This is also alarming, as excess debt issuance by the riskiest countries could be a telling sign of sign of things to come.

We have other concerns as well.  The stalled Brexit talks have U.K. Prime Minister Theresa May under fire, and the longer this goes on, the greater the uncertainty for the markets, especially for the U.K.  We also believe that U.S. equity markets are looking more and more expensive from a valuation perspective, which implies that we are long overdue for a correction of some magnitude.  Whether this is sparked by an escalation of a geopolitical event, credit crisis overseas, or some other unknown black-swan event, we will just have to wait and see.  But at the risk of sounding redundant, we continue to believe that the current situation of low unemployment, moderate inflation, accommodative monetary policy, and improving corporate earnings all point to continued economic growth.  High consumer confidence levels yet a lack of investor euphoria both add credence to our case. Therefore, we remain cautiously optimistic that this bull market will continue, especially for international equities.   November and December are historically some of the best performing months for equities… if we can finish 2017 the way we started, this would give us all something to be thankful for.

Happy Thanksgiving to all… May you enjoy the time with your families, and be thankful for the blessings in your life!

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