January 22, 2018
THE END OF AN ERA
It’s really hard to take your eyes off the stock market! The relentless march higher is both alluring and thrilling. After back-to-back years of double-digit returns, the nine-year-old bull market is now the second-longest and second-strongest in history. Resurgent global economic growth, blockbuster corporate profits, and optimism around tax reform are driving investors toward risky long-term assets. 2017 saw emerging market stocks surge 37.2%, foreign stocks gain 25.0%, and U.S. stocks rise 21.8% on the heels of strong global earnings and a weaker dollar. It seems like the wind is at our backs.
While we’ve been watching the stock market scale new heights, we worry that an unfamiliar monster is sneaking up behind us. The first whiff showed up this quarter when bonds started to underperform cash. Interest rates are rising, which means the 35-year era of falling interest rates may finally be coming to an end. Few are prepared: only 4% of financial analysts were in the business when interest rates were rising!
This is where experience counts. We’ve been investing on behalf of clients through seven full market cycles dating back to the 1970’s. When you’ve been around the block seven times, you get to be pretty good at recognizing patterns and knowing the appropriate action to take.
We believe the monster breathing down our neck today is not a run-of-the-mill market correction, or a ballooning budget deficit, or a recession. We’ve seen all that before – it’s just another lap around the block, which is manageable if your time horizon is seven years or longer. Another credit crisis would be a worthy villain, but we believe that monster has been vanquished for the time being.
Now, when it comes to our clients’ portfolios, the monster we worry about most is high inflation. We’ve talked in these pages about the wage-price spiral, but perhaps it’s not clear why high inflation is so awful for investors. Inflation makes tomorrow’s dollars worth less, which makes it harder to meet future financial goals. It makes lenders demand higher interest rates; the cost of capital goes up. Policymakers raise the price of money to offset the depreciating value of the currency as international competitiveness suffers. Rising budget and trade deficits lead to new debt issuance, and increased debt service costs and lower real return expectations choke off demand for the supply of debt. (This is not just an academic exercise. It’s been afflicting the United Kingdom for several years.) The inflation-interest rate spiral is very difficult to arrest once it gets going.
Bonds suffer with high inflation, but stocks do well, to a point. We know we will eventually need to trim stock allocations from excessive levels. When that time comes, the question is, should we buy bonds?
To be sure, a little inflation is a good thing – companies earn more, wages rise, stocks do well, and cash finally starts to yield something. We’ve all but forgotten what it was like to actually earn interest on our savings accounts! Sure enough, starting about 18 months ago, short-term interest rates began a slow climb higher. 3-month Treasury-bills are now yielding 1.42%, around 1.1% below 10-year Treasury bonds.
So, where is the inflation monster today? Safely hibernating under the bed. In 2017 year-over-year inflation was just 2.1%, far from the 4% level that would start to give us real cause for concern. Yet we fear the seeds of inflation are being sown by tax cuts, deregulation, nationalist policies, and competition for scarce workers. Further interest rate increases and rising inflation expectations could tip bonds into negative total return territory – which means cash would outperform bonds.
The last time interest rates suddenly rose 1% was in May 2013. Then, the bond market lost around 4% in a matter of weeks, and it took several months to claw back to break-even as the rate increase proved fleeting. This time around, rate increases don’t appear to be temporary. The Federal Reserve began to raise short-term rates over a year ago and expects to hike another 0.75% this year. Central banks in China, Europe, England, and Japan are making similar policy shifts. Inflation expectations are creeping higher, and celebrity investors are hitting the airwaves touting “the beginning of the end” for bonds.
Indeed, there are several reasons to be concerned about the risk in bonds:
- The low level of interest income doesn’t offer much cushion for price declines.
- The Federal Reserve is expected to raise short-term rates 2-3 times this year.
- Global central banks are gradually taking their foot off the gas pedal via less accommodative policies.
- Uncertainty surrounds the change in leadership at the Fed.
- Treasury supply is increasing as a result of the rising U.S. budget deficit.
- Companies with foreign reserves held in government bonds will likely sell those bonds to reinvest in share buybacks or capital spending in the U.S. when they repatriate the cash under the new tax law.
- Inflation expectations may rise as a result of late-cycle fiscal stimulus.
- Foreign central banks like China may decide to reduce their Treasury holdings as they prop up their currencies.
That said, we would not avoid bonds altogether. Bonds still play a very important role in client portfolios. Remember, a bad year for bonds is a loss of 4%, not 40%! Bonds do well in periods of heightened uncertainty and volatility. They provide current cash flow and dampen stock market risk. We believe a sudden, sharp increase in yields – a sell-off in bond prices – is unlikely. Bond-friendly risks facing us today include contentious negotiations in Congress over the debt ceiling, midterm elections, and heightened geopolitical risks (Iran, Syria, North Korea). Long-term interest rates rarely rise much when the Fed is raising short-term rates because the Fed action slows the economy, restrains lending, and crimps inflation – all of which keep a lid on longer-term rates.
With the backdrop of still-benign inflation, still-low interest rates, and an economy firing on all cylinders, we remain fully invested and prefer holding bonds instead of cash.
 “Only 4% of [Chartered Financial Analysts] were engaged in the field when interest rates were rising. Of more concern is that 35% of CFAs have been professional investors for eight years or less.” Source: Strategas, 1/2/2018
MARKET REVIEW AND OUTLOOK
Stocks shrugged off hurricanes and rising oil prices to post their ninth consecutive quarter of gains. Volatility is at record low levels: the S&P 500 Index has gone 14 months without a 3%-plus drop, the longest stretch on record. Growth-oriented stocks, large stocks, and blue-chip names continued to outperform smaller, more defensive issues. Heading into 2018, U.S. investors are focusing on political risks, tax reform, big-name tech stocks, and rising interest rates. Sentiment is positive: jobs are plentiful, taxes are being cut, and wages are rising faster than prices.
Bonds managed to eke out a modest gain, up 2.1% for the year. As expected, the Fed raised interest rates 0.25% in December, the fourth hike since they began normalizing rates in 2016. The yield on the 10-year Treasury closed the year at 2.41%, just below the 2.45% level at the start of the year, while short-term bond yields rose 0.70% for the year. Oil prices gained 17% in the fourth quarter to close the year at $60.42/barrel, and gold prices rose 2% to end the year at $1,306/ounce.
As we look ahead we, like most people, are tempted to project the current environment into the future. Indeed, we don’t see anything on the horizon that would derail the current moderate-growth economy. Global fundamentals are strong, policy is supportive, and the risks of a recession are very low. Stocks are not cheap so we are harvesting gains where portfolios are bumping up against the upper limits of allocation ranges, but we continue to prefer stocks over bonds, and we are keeping cash allocations very low except for client-specific liquidity needs.
Thank you for entrusting us with you investments.
If you have any questions about your portfolio or about the markets in general, please contact us at 206-223-9790. We stand ready to assist you.
“Only 4% of CFAs were engaged in the field when interest rates were rising. Of more concern is that 35% of CFAs have been professional investors for eight years or less.” CFA refers to professionals who have earned the Chartered Financial Analyst designation. Source: Strategas, 1/2/2018
While the information in our newsletter is obtained from reliable sources, we do not guarantee the accuracy of the information. Past results are not an indication of future performance. This report is not intended to be either an expressed or implied guarantee of actual performance, is not intended to supply tax or legal advice, and there is no solicitation to buy or sell securities.