Posts tagged Fed And The Markets
The bond market has been an active place of late. The Fed’s monetary policy pivot back in January (and an even more dovish position in March), a tempered outlook on global economic growth and related concerns have sparked a broad-based bond rally, with falling yields across most fixed income asset classes. We have been getting a number of questions from our clients about how these dynamics affect the returns they are seeing in the fixed income securities in their portfolios. So here are some key things to keep in mind when you are reviewing the bond portion of your portfolio.
It’s All In the Math
One question that comes up frequently is what drives relative performance between similar securities (e.g., governments or corporates) with different maturities. Consider, for example, the Treasury market. The chart below shows the relative yield trends of the 10-year Treasury note, a key benchmark for intermediate term bonds, and the 2-year note, a popular proxy for short term issues, so far this year.
Two things jump out in this chart. First, the spread between these two bonds is relatively tight. Currently just 18 basis points (0.18 percent) separate the 10-year and 2-year yields. The second thing is that the relative movement of each yield has been remarkably similar: when one goes up so does the other, and vice versa.
But when you look at the total return performance in your portfolio you will notice that they are not the same, or similar, at all. For example, the total return for the iShares 1-3 year Treasury ETF (SHY) for the year to date as of April 4 was 0.88 percent. The total return for the iShares 7-10 year Treasury ETF (IEF) was 2.15 percent. Big difference! What gives?
Fortunately, the answer is very simple: it’s all about the math. Bond pricing is entirely and completely driven by math. It’s all about the rate of interest and the magnitude & timing of a bond’s periodic interest and principal payments. The math works such that, for any incremental change in interest rates, the price of a longer-dated security will change by more than the price of a shorter-dated security. So, to use the example of the 2-year and the 10-year bonds in the above chart, the same decrease in the rate of interest will cause the longer-term price to appreciate by more than the shorter-term one. That’s why, all else being equal, bonds with longer maturities (or effective duration, which is a measure by which we compare the relative effect of interest rate changes) have outperformed ones with shorter durations this year.
A Bond’s Purpose
If you knew that interest rates were going to go down for a long time then, all else being equal, you would want to position your portfolio to capture the benefits of longer duration. Conversely, if your vision of the future is one of rising rates, then you are interested in shorter-dated securities as a way to reduce interest rate risk. Of course, nobody can ever know for certain which way rates are going to trend (think, for example, of the Fed’s complete U-turn between its December and January meetings). The answer – or our approach, in any case – is to maintain a range of short to intermediate duration exposures with an eye to mitigating the risk of a sudden jump in rates.
Ours is a fairly conservative approach for the simple reason that for our portfolios, the fixed income portion is where you go for safety, not for outperformance. Bonds are for stability (predictability of the size and timing of income streams) and for cushion against the risks to which other asset classes – primarily equities – are exposed. And it is those riskier asset classes – again, not bonds – where we actively seek growth through capital appreciation.
The total size of our fixed income allocation may change – higher or lower as a percentage of total portfolio assets depending on our overall market and economic outlook. But you won’t find us aggressively chasing returns through active duration management, because that is not why we have bonds in the first place.
It’s quite a world, this one we inhabit. Today is Brexit Day! Article 50 goes into effect at 11 pm Greenwich Mean Time…except, of course, that it doesn’t, because our esteemed and honourable Members of Parliament are still having an existential debate regarding what Brexit is all about (real time update: the debate is over, again, with no agreement, again). The Monty Python sketch about Silly Upper Class Twits comes to mind. But no matter! We have nothing more to say about Brexit other than commiserations for the 48 percent of the citizenry of the Isles who never wanted this farce in the first place. We are here to talk about one of the other surreal features of our present day Planet Earth. Negative interest rates are back, and they are back with a vengeance. Here’s a snapshot of the yield trend for the German 10-year Bund, the go-to safe haven asset for the European Union.
What Don’t We Know?
The German Bund’s fall back into negative rate Wonderland is, of course, just one part of a massive global rally in bonds. Last week we talked about the inversion of the US yield curve and what that may mean for fixed income and equity investors in the weeks and months ahead. Elsewhere in the world the same trend is playing out. Take, for example, New Zealand. The 10-year Kiwi, as the country’s government bonds are known, hit record low yields this week. Not “52 week low” or even “five year low” but actual record low. The Kiwi’s 10-year journey towards Wonderland (it has not yet gone through the looking glass to negative rates) is shown in the chart below.
The sharp rally in Kiwi prices (bond prices move inversely to their yields) has much to do with the effects of a China slowdown on economies in the Asia Pacific Region. It’s not the directional trend as much as the speed of this global bond rally that is surprising, however. After all, we have known for many months now that growth in China was slowing and that further potential negative risks lurked in the form of a worsening US-China trade environment. We knew this in September and December of last year, when the Fed pronounced a robust bill of health on the economy enabling future rate hikes. What was it, starting in January this year and snowballing through the first quarter, that caused first the Fed, then the ECB, and then pretty much everyone else to out-dove themselves? What do they know that we don’t?
Data Not There Yet
The right answer to that last question may well be…nothing. After all, the central banks aren’t directly responsible for the pace of this bond market rally. Traders are…and by traders we mean, of course, algorithm-driven bots primed to move whatever way the mass consciousness of the digital world seems to be going. Trading by Twitter. It is entirely possible that this rally is already overbought, with bond yields potentially set to return to less gloom-and-doom territory.
After all, the global economy is not in recession and the data still do not suggest it is heading towards one in the coming months. Here in the US we have one month of lousy job numbers and inflation still struggling to maintain a two percent range (the latest Core Personal Consumption Expenditure rate, released today, is 1.8 percent). Q1 GDP is expected to come in below two percent, but weak first quarters are not unusual. Not great, but not too bad. The IMF’s latest projection for real global GDP growth for 2019 is 3.5 percent – down from earlier projections but, again, still comfortably north of zero.
Postmodern Financial Theory
Yes, but what about the inverted yield curve we talked about last week? That hasn’t gone away, and it remains the most prescient harbinger of forthcoming recessions, based on past instances. Is there something different about fixed income markets now that possibly makes this indicator less useful than it once was? Well, yes actually. In no past recession, ever, was there the presence of unconventional monetary policy all around the world. No negative interest rates. These aren’t even supposed to exist according to the conventions of modern financial theory. A dollar today is worth more than a dollar tomorrow, and the rate of interest that expresses a future value in present value terms is positive – that’s why it is called the discount rate.
But we have negative interest rates today, in many parts of the world, and they have the effect of flattening curves in markets where rates are still positive (like the US). The real (inflation-adjusted) rate of return on a 10-year US Treasury note may be barely positive (as is the case today) but it is still a whole lot more attractive than actually paying the German government for the “privilege” of holding its 10-year debt in your portfolio. This is not normal – and it may well suggest that we should not be reading too many recessionary warnings into these tea leaves.
What to do, then? Well, this is Wonderland. Whatever emergent properties bubble out of the current soup of variables at play could go one way, and they could go the other way. Anyone who tells you they know which way that is, well, they probably also have a bridge to sell you. A little caution, without an undue reduction of exposure to growth, is how we have been positioning the portfolios under our discretion. That course of action still seems reasonable to us.
As we wind our way through the random twists and turns of the first quarter, a couple things seem to be taking on a higher degree of likelihood and importance than others: (a) the Fed is back in the game as the dice-roller’s best friend, and (b) corporate earnings are starting to look decidedly unfriendly for fiscal quarters ahead. And we got to thinking…have we seen this movie before? Why, yes we have! It’s called the Corridor Trade, and it was a feature of stock market performance for quite a long time in the middle of this decade. Consider the chart below, which shows the performance path of the S&P 500 throughout calendar years 2015 and 2016.
What the chart above shows is that from about February 2015 to July 2016, the S&P 500 mostly traded in a corridor range bounded roughly by a fairly narrow 100 points of difference: about 2130 on the upside, and 2030 or so on the downside. There were two major pullbacks of relatively brief duration during this period, both related to various concerns about growth and financial stability in China, but otherwise the corridor was the dominant trading pattern for this year and a half. Prices finally broke out on the upside, paradoxically enough, a few days after the UK’s Brexit vote in late June 2016. An overnight panic on the night of the Brexit vote promptly turned into a decisive relief rally because the world hadn’t actually ended, or something. A second relief rally followed the US 2016 elections when collective “wisdom” gelled around the whimsical “infrastructure-reflation” trade that in the end produced neither.
So what was this corridor all about? There are two parts: a valuation ceiling and a Fed floor.
Corridor Part 1: Valuation Ceiling
In 2015 concerns grew among investors about stretched asset valuations. Earnings and sales multiples on S&P 500 companies were at much higher levels than they had been during the peak years of the previous economic growth cycle in the mid-2000s. The chart below shows the price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500 during this period.
Those valuation ratios were as high as they were during this time mostly because sales and earnings growth had not been keeping up with the fast pace of stock price growth in 2013 and 2014. While still not close to the stratospheric levels of the late-1990s, the stretched valuations were a cause of concern. In essence, the price of a stock is fundamentally nothing more and nothing less than a net present value summation of future potential free cash flows. Prices may rise in the short term for myriad other reasons, causing P/E and P/S ratios to trade above what the fundamentals might suggest, but at some point gravity reasserts itself. That was the valuation ceiling.
Corridor Part 2: The Fed Floor
The floor part of the corridor is just a different expression for our old friend, the “Fed put” begat by Alan Greenspan and bequeathed to Ben Bernanke, Janet Yellen and now Jerome Powell. Notice, in that earlier price chart, how prices recovered after both troughs of the double-dip China pullback to trade again just above that corridor floor level. The same thing seems to be happening now, with the extended relief rally that bounced off the Christmas Eve sell-off. The floor is a sign of confidence among market participants that the Fed won’t let them suffer unduly (which confidence seems quite deserved after Chair Powell’s capitulation at the end of last month). It is not clear yet where the floor might establish itself. Or the ceiling, for that matter. Might the S&P 500 reclaim its September 20 record close before hitting a valuation ceiling? Maybe, and then again maybe not.
What we do know is that bottom line earnings per share are expected to show negative growth for the first quarter (we won’t find out whether this is the case or not until companies start reporting first quarter earnings in April). Sales growth still looks a bit better, in mid-single digits, but we are already seeing corporate management teams guiding expectations lower on the assumption that global growth, particularly in Europe and China, will continue to slow. Meanwhile price growth for the S&P 500 is already in double digits for the year to date. That would appear to be a set-up for the valuation ceiling to kick in sooner rather than later.
Could stock prices soar another ten percent or even more? Sure they could. The stock market is no stranger to irrationality. A giddy melt-up is also not unknown as a last coda before a more far-reaching turning of the trend. But both elements are pretty solidly in place for a valuation ceiling and a Fed floor. A 2015-style Corridor Trade will not come as any surprise should one materialize in the near future.
There is something almost symmetrical about it all. On December 19 last year the Federal Reserve delivered a hawkish monetary policy statement that sent the stock market into a tailspin. Two days later the US government shut down. Fast forward to January 25 of this year. The US government reopened amid generally upbeat sentiment in asset markets. Several days later, the Fed surprised traders with a decidedly dovish policy statement hinting at a pause, not only in further interest rate hikes but in winding down the central bank’s balance sheet of bonds purchased during the quantitative easing (QE) era of 2008-14. Stocks surged in the aftermath of that announcement and closed out a January for the record books. Hallelujah, exclaims Mr. Market. The Fed put is back and better than ever!
What Exactly Changed?
The January Federal Reserve Open Market Committee (FOMC) statement was not just a tweak or two away from the December communiqué – no, this was closer to a full-blown U-turn. As much as investors thrilled to the news that the Fed was solidly back in their corner to privatize gains and socialize losses, there was quite a bit of head-scratching over what exactly was so momentously different in the world over this 30 day interval. The FOMC press release seemed to say little about changes in economic growth prospects, with a strong labor market and moderate inflation paving the way for a sustained run of this growth cycle. True, it chose the world “solid” to characterize growth, which may be a slight demotion from “strong” as the adjective of choice in December. And yes, muted inflation affords some leeway to adjust policy if actual data were to come to light. But real (inflation-adjusted) rates are nowhere near recent historical norms, as illustrated in the chart below.
“Muted inflation” is the Fed’s term to describe the current level – but is it really “muted?” The chart above shows the Consumer Price Index (the blue dotted line) to be squarely within a normal range consistent with growth market cycles in the late 1990s and the mid-2000s. Yet in both of those cycles real rates were much higher, as is clear from the gap between nominal 2-year and 10-year yields (green and crimson respectively) and the CPI. Is the Fed worried that real rates at those levels today would be harmful? If so, there must be some element of fragility to the current economy that wasn’t there before.
Oh, Right. That.
Or, maybe that’s not it at all, as the FOMC press release sort of gives away in the next sentence. “In light of global economic and financial developments…” Aha, there it is, the language of the 2016 Yellen put reborn as the 2019 Powell put. What, pray tell, could those “financial developments” possibly be? A stock market pullback, blame for which was almost entirely laid at the feet of those two FOMC press releases last September and December? Once again, monetary policy appears to be based principally on ensuring that market forces not be given free enough latitude to inflict actual damage on investment returns.
And maybe that’s fine – perhaps the pace of growth will continue to be slow enough to allow the Fed to ease off the monetary brakes without any collateral damage. If that turns out not to be the case, though, then we foresee some communication challenges ahead. The data continue to suggest the growth cycle has a way to go before petering out. Today’s jobs report was once again robust, with year-on-year wage growth solidifying a trend in the area of 3.2 percent year-on-year. Unfortunately we won’t know about Q4 2018 GDP for some time, as the Bureau of Economic Analysis was impacted by the government shutdown and does not yet have a date for when its analysis will be ready for release.
March is probably safe – the likelihood of a rate hike then is now close to zero. But if Powell has to go back to the market sometime later in the year and ask investors to get their heads around another rate hike – a U-turn from the U-turn, in effect – that would likely be problematic. This Fed still has a learning curve to master when it comes to clarity of communication.
It wasn’t all that long ago that Davos Week was a big deal. Confident, important communiqués about the state of the world delivered by important, impeccably tailored men (and a few women here and there). The rest of the world’s inhabitants might live out their quotidian habits in a perpetual fog, but the great and good who assembled in the little Swiss Alpine town every January were there to tell us that it was all going to be okay, that the wonders of the global wealth machine would soon be trickling their way. Now the fog has enshrouded them as well. While their status as influencers was getting sucked down into the lowest-common-denominator Twitterverse, their ability to explain the great trends of the day was upended by the improbable turn those trends were taking away from the comfortable Washington Consensus globalism of years past. “The mood here is subdued, cautious and apprehensive” reports Washington Post columnist (and Davos Man in good standing) Fareed Zakaria from the snowy slopes this year. Apprehensive, not confident, which is an apt way to sum up the present mindset of the world.
Never Underestimate the Power of Kick the Can
Yet, for all the fretting and fussing among the stewards of the world’s wealth pile, some of the key risks that have been plaguing investors in recent weeks seem to be turning rather benign. Consider as Exhibit A the state of the British pound, shown versus the US dollar in the chart below.
The pound has rallied strongly since plummeting in early December last year. If you go back and track the history of Brexit negotiations since that time, you find that the actual news about a Brexit resolution is almost all dismal. The deal PM Theresa May brought back from Brussels was panned as soon as it reached Westminster; that same deal formally went down to one of the most ignominious defeats in UK parliamentary history last week.
All the while – the pound sterling has rallied! Why? Because the Brexit deal’s unpopularity means that there are only two ways this whole sorry affair plays out between now and March, when the Article 50 deadline comes into effect. One is that the UK crashes hard out of the EU, which would be a disaster for the country. The other – and far and away the most likely, is to kick the can down the road. Extend the Article 50 deadline, probably to the end of the year, and see what kind of fudge can be worked out between now and then. Maybe (most likely, as we have been saying for some time now) a second referendum that scotches Brexit for once and all. Maybe something else. Maybe someone has to make a bold decision at some point. But not yet, not yet, as that fellow said in “Gladiator.” Thus the strong pound.
March Without the Madness
The month of March has in fact been looming large over Davos think-fests and cocktail parties this week. In addition to Article 50, there is that self-imposed deadline by Washington’s trade warriors to reach some kind of deal with China on the terms of cooperation going forward – absent which, according to Trump’s protectionist acolytes, there would be hell to pay in the form of new tariffs. Yet as the days go on, the evidence mounts that this administration’s tough talk on any number of fronts is all hat and no cowboy. This administration has plenty of other troubles with which to contend, and by now they know that actually following through with tough trade rhetoric will spark another pullback in the stock market. We don’t think it’s being Pollyanna to say that this trade showdown at high noon will likely not come to pass.
Finally, the other risk event that could befall markets after the Ides of March would be the Fed meeting that month with the potential for another interest rate hike. While that is a possibility, the Fed’s actions in recent weeks have been very cautious and non-confrontational with edgy markets. Recent inflation numbers have come in a bit below expectations. We’ll see what happens with Q4 GDP next week, but indications are that it will settle back somewhere in the 2-plus percent real growth range. In other words, the Fed will have plenty of flexibility if it decides to join in with the kick the can fun and hold off until next time. Even on the question of the Fed’s balance sheet there have been some recent indications that it may not wind down as quickly or deeply as previously thought.
“Never make tough decisions today that you can punt down the field for later” – this instinct is alive and well in the world of global policymaking. As long as that remains the case, Davos Man, you should take a deep breath and go back to enjoying your cocktails and canapés.