FEBRUARY INVESTMENT COMMENTARY
- Markets suffer their first correction since January 2016, but have since stabilized and are now in the midst of a “V” shaped recovery.
- U.S. 10-year Treasury yield has been on a tear in 2018, prompted by a hot economy, higher inflation expectations, and fiscal stimulation from tax cuts and spending.
- Higher yields have resulted in temporary negative returns in fixed income… but we reiterate why higher rates is a good thing for bonds in the long run.
- For the time being, our thesis has not changed. We continue to believe that synchronized global growth and accommodative monetary policy can keep this bull market going.
After an extended period of absence, volatility has finally reemerged into the marketplace. In our previous commentaries we had repeatedly noted that equity markets were long overdue for a 5-10% correction, which finally occurred in the early weeks of February, precipitated by fears of inflation and rising interest rates. As measured by the S&P 500, the market lost 2.12% on Friday February 2nd, 4.1% on Monday the 5th, and 3.75% on Thursday the 8th. Upon Thursday’s loss, the market closed -10.2% off of its previous all-time high, thus officially entering into “correction” territory. (Note: A decline of 10% is considered to be a correction, a decline of 20% is considered to be a bear market). However, since the market bottomed on February 9th, equities have rebounded quite impressively, as the S&P 500 briefly touched below its 200-day moving average, and is now testing its 50-day moving average as of February 15th.
Before this month, the market had not experienced a negative day of more than -3% since June of 2016. In fact, in the past 2 years, there have been only 17 trading days with losses exceeding -1%, and only 5 days with losses greater than -2%. This resulted in an extended period of extremely low volatility, as can be seen by observing the CBOE Volatility Index below. As it tends to do, volatility usually spikes once an unforeseen event rattles the market, and then settles back and trends lower over time. In this case, the unforeseen event happened to be higher wage growth (which normally would be considered good news, more on this later), that the market interpreted to be inflationary which would lead to higher rates. The selloff then accelerated, most likely due to algorithmic trading, and the unwinding of several short volatility trades which had been highly profitable for months.
As we mentioned in our recent investment update, the markets seemed to be looking for a reason to correct, and they found a catalyst within the context of higher rates and inflation. The thing is, rates and inflation are still relatively low by historical standards, and the underlying strength of the economy is still very much intact. This is one of the reasons why we feel that the market rebounded so quickly, because this was more of a technical correction (reaction to being overbought) rather than a fundamental one. We also believe that corporations, flush with cash from the tax cuts and jobs act, will continue to eagerly buy back their shares as they have for much of this current business cycle. The fact that we are in the thick of earnings season, where companies are restricted from buying their shares within 5 weeks after reporting earnings, has likely prevented some corporations from stepping in as buyers in previous days. We also saw a large number of investors get caught on the wrong side of a short volatility trade, which helped exasperate the selling during the correction. In fact, Credit Suisse had to shut down its popular inverse volatility ETF, as the fund which had $1.9 billion in assets, dropped by over 96% in one day. It appears, for now at least, that the majority of short volatility trades have been unwound, which should contribute to a more stable market.
Will Higher Inflation Expectations Prompt a More Aggressive Fed?
As previously mentioned, one of the primary culprits for the equity selloff was rising inflation expectations. The first sign occurred on February 2nd when Hourly Wage Increases, which has remained stubbornly low throughout this expansion, unexpectedly rose to 2.9% year-over-year, compared to 2.5% the month prior. While this is still well below where we should be given the mature economy and low unemployment, investors took this as a sign that the Fed may begin to raise rates faster than previously expected. However, it should be noted that prior to the past three recessions, average wage growth ran north of 4% annually before the economy turned downward.
Meanwhile, Congress finally passed their budget which President Trump signed, along with huge increases in spending to appease both sides of the aisle (aside from the fiscally conservative budget hawks). The bill increased spending by roughly $300 billion over the next two years, with $160 billion going to military and $130 billion going to domestic spending. It is fair to say that with this new bill we are now entering into a new age of unrestrained fiscal policy, and that this type of stimulus will almost certainly be inflationary down the road. In addition, evidence is starting to mount that inflation is creeping up as the global economy is beginning to run hot. Headline CPI (Consumer Price Index) increased 0.5% in December, and is up 2.1% year-over-year. 2.1% is certainly not indicative of an overheated economy, however a new upward trend does seem to be developing based on the factors listed above. Keeping the Fed’s dual mandate in mind, the Central Bank usually focuses on “Core” inflation which extracts food and energy due to its volatility. Core PCE inflation is still just at 1.52%, well below the Fed’s 2% mandate, however the notion that higher inflation might prompt faster rate hikes is certainly in the minds of equity and bond investors alike. According to the futures market, as of February 16th there is an 83% chance the Fed hikes rates to 1.5-1.75% in March, a 57% probability of another hike in June, and a 36% probability of a third hike in December. The probabilities of each have increased over the past month, so it seems more than likely now that we will get 3, or even 4 rate hikes this year.
Welcoming Higher Interest Rates
Fixed income products have had a tough go so far in 2018, as higher yields have pushed the broad fixed income indices down about 2% through the middle of February. Investors have long feared the implications of higher interest rates towards their fixed income portfolios. The notion of higher rates, which are inversely correlated with bond prices, has caused many to either underweight their bond holdings or avoid the asset class altogether. We believe that it is a significant mistake to avoid bonds for multiple reasons. First, high quality bonds generally exhibit lower correlations to equities, and usually benefit from a flight to quality during periods of economic distress. Second, the fact that rates are rising should be considered a good thing for bond investors, not the other way around. Yes, higher rates cause the price of bonds to decrease in the short run, but they do not affect the total return of bonds already owned. In other words, a bond’s total return is established when it is purchased, as it is represented by its ‘yield to maturity’, which is a function of both its price and coupon yield. Assuming the bond doesn’t default, the investor knows exactly what they will receive from a bond, regardless of what rates do. However, there is the aspect of reinvesting coupon payments and proceeds of maturing bonds, and in a rising rate environment, the proceeds are reinvested at higher rates which increases the total return of the portfolio. In a decreasing rate environment, the opposite applies as proceeds are invested at ever-lower yields.
What is important to remember, is that over any extended period of time, the vast majority of the total return of a bond comes from the income, and not the price movement. According to Factset, going back to January 30, 1976, the price return on the Bloomberg Barclay’s US Aggregate Bond Index was 0.15% annualized, while the total return was 7.33% annualized. This implies that about 98% of the total return came from the income produced by the bond coupons, which of course increases with rising rates. Another way to look at it is by observing periods of rapidly rising rates, as represented by the yield on 10-year treasuries. From October 15, 1993 through November 7, 1994, the 10-year treasury yield rose by 286 basis points from 5.17% to 8.03%. This caused the price return on the Barclay’s Aggregate index to fall by -11.99%, while the total return fell by -5.0%. For the one year period after November 7, 1994, the index rose by 9.27% in price terms, or 17.11% in total return terms. As you can see, the increase in yield more than made up for the negative return during the rising rate period. The same thing occurred from October 5, 1998 through January 21, 2000, when rates rose by 263 basis points from 4.16% to 6.79%. The one year period after rates rose resulted in a 13.54% total return, compared to -1.76% during the rising rate period.
Looking at the positive side of the recent bond selloff, it should be noted that spreads between credit sectors exhibited very little widening during the height of the equity selloff, which indicates the lack of a perceived increase in credit risk. The spread between Investment Grade Corporates widened from just 0.70% to 0.80%, which is still near multi-year lows. Meanwhile the spread between High Yield and Treasuries moved only 35 basis points from 3.4% to about 3.75%, and has since retreated back to 3.58%. These are clearly positive signs, and supporting evidence that the scare in equities had nothing to do with the underlying strength and credit quality of corporations.
Despite a Few Potholes, the Road Ahead Seems Navigable
In many ways, it should be considered a positive sign that the stock market sold off so viciously and found support in a relatively short period of time. Equities had a terrific run in 2017, capped off by a holiday gift of lower taxes from Washington. From a fundamental standpoint, the global backdrop of a strong economy supported higher equity prices, yet from a technical standpoint we were long overdue for a selloff. We believe it is always important to distinguish that the market and the economy are two different things, and that the market can and will act irrationally for periods of time. As we know, what goes up must come down at some point, and the stock market is always a forward looking indicator as to what is going on in the economy.
That being said, we find it highly unlikely that we will enter into another sustained period of low volatility, but we do believe that this bull market in equities can continue. Higher rates will certainly create headwinds, but even with a 10-year yield in the mid 3% range, we hardly find this to be unaccommodating for business. Strong corporate earnings, lower tax rates, and infrastructure spending should support the economy at home, while overseas, easy monetary policies, low unemployment, and global synchronized growth should drive the economy and markets higher. Future Fed policy, including short term rate hikes and balance sheet normalization top our concerns as this expansion continues on into 2018. New Fed President Jerome Powell certainly has a daunting task ahead of him, with inflation on the rise, a nine year old bull market, and an Administration set on pumping more stimulus into the economy. Eventually something’s got to give, but for now it appears we still have a few more miles to go before we reach the end of the road.