Written by Luke Patterson | Wednesday, May 30th, 2018
INSIDE THIS EDITION:
Geopolitics, Debt and Markets
Do You Have A Risk-Balanced Portfolio for Retirement?
Weekly Technical Comment
Memorial Day Weekend: Interview with Valor Services 401k Plan Manager
The market did little last week. The Dow only advanced 0.2 percent while smaller stocks barely moved. Geopolitical issues had an impact as North Korea seems to play cat and mouse, trade issues between the U.S. and China remain, and stocks closed lower yesterday largely due to investors being fearful of the political turmoil in Italy.
Predicting market moves based on geopolitical activities is difficult. That said, risk aversion is back. Market reporting is prone to hyperbole, but Tuesday’s Italian bond selloff was truly astonishing. Short-dated bonds that can usually be treated as a close proxy for cash turned toxic, and bondholders showed serious panic. Prices fell and yields on short-dated bonds rose as much or more than when the euro was fighting for survival in 2011 and 2012. Many people say that Italy had a 130% government debt-to-GDP, and that most of this debt is held internally, so who cares?
Well, that obscures the grim reality that Italy’s banking system is structurally unsound. Non-performing loans exceed €85 billion, the most of any EU country – 11.1% of total loans outstanding. France’s ratio is 3.1%, Germany’s is 1.9% and the Netherland’s is 2.2%. Even Spain with all its challenges, is 4.3%. Italy also has the third-highest public debt in the world and so this has really spooked the bond markets.
The mistake many investors have made is to confuse a coincidence of a pick-up in growth around the world with something that has legs. It’s possible it is all a lucky coincidence. Europe’s deepening troubles and disappointing global growth signals are sparking a sudden rally in safe haven assets like U.S. Treasuries. Yields on the 10-Year Treasury have come down from 3.13% to 2.8%, and after hitting a high on January 26th, the equity markets corrected in early February and have since been stuck.
There is good reason to think a further rise in bond yields will be self-limiting. A debt-ridden world cannot sustain high interest rates for long. Perhaps long-term interest rates will move higher over time. But let’s not be surprised if they fall again first.First quarter earnings are coming to a close, but the results have been fairly solid. The percentage of stocks with a positive earnings surprise is close to record levels. Despite this the market still struggles to break out. First, the Fed is pushing against the market with higher rates and Quantitative Tightening. Second, valuations remain high; the P/E on the S&P 500 is around 21. As we have pointed out before, stocks now have competition from cash as the 90-day T-bill, essentially the risk-free rate of return, has a higher yield than dividends on the S&P 500. Lastly, several technical indicators have also turned negative.
The market has been stuck in a trading range since January. We do not expect this to change in the near future, but some risks have been rising. Valuations in general remain high and stocks must compete with the higher short-term yields. We think it is prudent to avoid being overly aggressive in equity levels.
Do You Have A Risk-Balanced Portfolio for Retirement?
Many investors allocate assets in line with a “Balanced Portfolio”, which is composed of 60% stocks and 40% bonds. In a traditional balanced portfolio, bonds are thought to act as a good hedge to stocks, because bonds tend to go up when stocks go down. However, this relationship (the negative correlation between stocks and bonds) only holds when a market shock stems from the side of growth, like during a recession when economic growth experiences an unexpected slowdown. If a market shock stems from unexpected inflation, which typically happens with an overheating economy, then the negative correlation of stocks and bonds breaks. This means that stocks and bonds can go down at the same time.
Fortunately, for much of the past 30 years, the overall macroeconomic environment was largely disinflationary, so interest rates kept going down. As a result, bonds generated strong returns on their own while providing a critical offset to stock risk at times when markets sold off. For many investors, a static/passive balanced portfolio allocated between US large cap stocks and U.S. Treasury bonds has become a default option, given it has worked very well for a prolonged period.
However, the current macroeconomic backdrop is like the late 60s in the U.S., where monetary policy was ultra-accommodative, inflation was on the rise, unemployment rate was low, and a hefty boost of fiscal stimulus (great society programs and Vietnam War spending) kicked in. All while the business cycle approached its later stage. What happened subsequently was that a sharp rise in inflation and a Federal Reserve in “inflation-fighting mode” led to an eventual economic recession. When rising inflation, rather than slower growth, pushed the economy into recession, both stocks and bonds had negative price returns for years (see chart below). In February of 2018, the fear of a sudden rise in future inflation drove down the value of both stocks and bonds in the most recent example higher correlations between stocks and bonds.
A sharp rise in inflation is not our base case scenario, due to several structural disinflationary factors including an aging population, technological advancement, and globalization. However, even a persistent moderate inflation level may be detrimental to retiree investment portfolios. Thus, careful consideration should be given to the tools available for hedging inflation risk. This is especially true as most income sources for retirees are not inflation-hedged (bond coupon payments, annuity income, pension income, and death benefits in life insurance policies) and not all financial assets have priced in the potential for upside surprises in future inflation.
As such, the investment portfolio for a retiree needs to balance both left-side risk (recession) and right-side risk (overheating economy). Currently, macroeconomic factors support risk on either side. But if history can be any guide, the economy is most likely to experience some overheating, because of fiscal stimulus, before rolling into a recession caused by an overtightening of financial conditions. Due to the directional change and uncertainty around the inflection point, it is paramount to actively manage a portfolio and remain flexible and adaptive. In terms of fixed income, if recession is imminent, some long duration strategies either in core fixed income or municipal bonds can help hedge market risk; if inflationary shocks are more of a concern, then short-duration, floating rate, inflation-linked and credit strategies could be beneficial.
Political Uncertainties in Italy Rattle Global Markets
Political uncertainties in Italy and Spain rattled global markets on Tuesday, leaving the Dow Jones with a loss of nearly 400 points on the session. The Euro Stoxx 600 sagged 1.4% in the worst session since March 22. There was a clear flight to safety, underscored by a massive 16 basis point drop in the 10-year treasury yield ($TNX) as it fell to 2.77%. See below:
That precipitous drop caused significant selling in financial stocks (XLF, -3.34%). The Dow Jones U.S. Banks Index ($DJUSBK, -3.75%) had one of its sharpest declines in 2018 as the 10-year treasury yield ($TNX) plunged to nearly reach a two month low. If there’s a silver lining, it’s that the DJUSBK held key short- to intermediate-term price support as reflected below:
It has been a very rough four days for banks since their failed breakout attempt above gap resistance. It’s been accompanied by a huge drop in the 10-year treasury yield, so it stands to reason that a bounce in treasury yields would allow the DJUSBK to hold onto support at 450-455 once again. We’ll see.
There was plenty of collateral damage as well. Basic materials (XLB, -1.73%) and industrials (XLI, -1.60%) both absorbed plenty of pain. The S&P 500 broke below the 100-day moving average and the Volatility Index ($VIX) soared almost 30%, finishing back at that pivotal 17 level.
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
Memorial Day Weekend: Valor Services Interview
For Memorial Day Weekend, we spoke with Steve Yen and Valerie Hamilton of Valor Services. Valor Services leverage a fusion of combined military leadership and organizational expertise, with a suite of top-tier professional services to deliver several solutions that include talent acquisition, workforce, and organizational development. Valor’s unique incorporation of the best aspects of military culture into private sector capabilities, arms them with a powerful platform with which to passionately champion our military veterans transition back into civilian life and post-military career advancement.
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