15 Oct Q3 2018 Market Commentary
Director of Investments Todd Jones, MBA, CAIA®, weighs in on the current financial environment and critical market trends.
Here’s what Todd is talking about this quarter:
• US interest rates have made a noticeable move higher since the end of the third quarter. Is this movement concerning?
• Do bonds still have a place in our portfolio now that you think interest rates are heading higher?
• Emerging markets seem to be experiencing performance challenges. Do you have any updated thoughts on this segment in the equity market?
US interest rates have made a noticeable move higher since the end of the third quarter. Is this movement concerning?
The recent push higher in long-term US Treasury yields has made us revisit our thesis on the future path of interest rates.
In prior years, our thinking was that longer-dated bonds (10-30yr) would continue to gyrate within the well-established channel seen above while shorter-term bonds (2-5yr) would move up in lockstep with changes in the Federal Funds rate. At the start of the fourth quarter, however, the yield on the 30yr bond has now moved up through the top end of this 32-year channel, possibly indicating a secular change in interest rates (see chart above). We are now expecting interest rates across the US Treasury yield curve to migrate higher over time as growing inflationary pressures, combined with expanding US budgetary deficits, create higher structural interest rates. Is this trend change in interest rates important/worrisome? We believe that this trend change is important but not (yet) worrisome for our fixed income strategies. A typical bond portfolio of fixed rate bonds carries two key risks: (1) credit risk (or the risk of a bond default), and (2) duration risk (or how long it would take a bond portfolio to self-liquidate). When interest rates rise, fixed-rate bond portfolios with a long duration will drop in value because the current coupon is less valuable as current interest rates are higher. For example, if you had a bond with a 10yr duration and interest rates moved up 1% in one day, the value of that bond would drop by 10% (1 x 10). If interest rates moved up by 2% in one day, then the bond would move down by 20% (2 x 10). These examples illustrate how perilous it can be to own long-term bonds in the current environment. We are not concerned, though, because we believe we are positioned appropriately to actually benefit from a rise in interest rates via our portfolio’s holdings in floating-rate bonds and modest interest rate hedges.
Do bonds still have a place in our portfolio now that you think interest rates are heading higher?
Bonds continue to play a valuable role in our portfolios for two primary reasons: (1) dependable income generation and (2) portfolio ballast. Unlike stock dividends, bond interest is a contractual obligation that must be paid ahead of all other parties and is an obligation of the issuer. This is very different from a stock dividend, because stock dividends are a discretionary payment made by a company to shareholders. In difficult economic conditions, many companies will curtail, or even eliminate, stock dividends in an effort to preserve cash. For anyone who depends on their portfolio for a portion of their lifestyle needs, it’s important to maintain a dependable income stream. Achieving balance is critical to long-term success in a portfolio, because the recovery from a challenging period in the equity markets is a lot easier for a portfolio if the drawdown is mitigated. Portfolios also need to have different (ideally non-correlated) sources of return. Historically, equity returns and bond returns have shown zero, and even negative, correlation to each other over long periods of time. Now, however, equity and bond returns (at the index level) are beginning to show a positive correlation for the first time in a while. It is critical to know what you own so as to preserve those correlation benefits. In summary, when carefully constructed to maintain the historical zero/negative correlation to equity markets, bond investments remain a valuable holding in any diversified portfolio.
Emerging markets seem to be experiencing performance challenges. Do you have any updated thoughts on this segment in the equity market?
After another strong start in 2018, emerging markets (proxied by the EEM ETF shown in the chart above) are now trading 23% off their peak levels in January, which puts the asset category firmly into bear market territory. In our view, there are a number of factors at play right now which make EM stocks unattractive. One of the biggest factors continues to be political risk. Countries like Brazil and South Africa are showcasing this risk, where the outcome of various elections can have a detrimental effect on the long-term growth potential of a country’s economy. The bottom line, however, is that EM stocks need to get cheaper for us to get interested again.
Do you have any final thoughts?
We continue to believe that there are opportunities in large US companies. Not dissimilar to the years 1996-1999, value stocks (banks, materials, industrials, healthcare) have dramatically underperformed growth stocks (technology, consumer discretionary) by a margin of ~30% over the last two years. This is not to say companies like Amazon and Google can’t continue to have decent performance over the next 12 months. Yet, with interest rates rising, the bar is getting higher for growth companies as low-cost capital becomes harder to source. This dynamic is certainly starting to play out in the first part of the fourth quarter. With a growing US economy and continued increases in interest rates, we believe that equity markets will be supportive into the early part of 2019.
 In all actuality, the bond market has been sniffing out this change in regime ever since the 2016 US Presidential election. On the day of Donald Trump’s win (November 8th, 2016), 30yr US Treasury bond yields went from 2.63% to 2.89%.
Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of October 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.