Sellwood’s August 2018 Market Snapshot is available for download.
Second Quarter 2018: Tit for Tat
Tit-for-tat trade retaliation took center stage during the second quarter. Canada levied retaliatory tariffs on wide variety of US agricultural products in response to steel and aluminum tariffs announced by the Trump administration in March. China likewise promised to retaliate along the same lines. As the quarter ended, President Trump raised the possibility of escalating the conflict with 20% tariffs on imported European automobiles, a move which EU Officials were quick to condemn.
Italian political turmoil roiled international markets as a new government raised the possibility of Italy exiting the European Union. Italian equity markets sold off sharply while bond yields rose, pushing Spanish and Portuguese yields higher, reminiscent of past European debt crises. The trade and politic turmoil pulled developed international equity prices downward in the quarter, with European financials heavily impacted. Emerging market stocks were also heavily hit. Causes ranged from NAFTA trade worries in Mexico, growth problems in Brazil, to continual political problems in Turkey.
Despite trade woes, US stocks were up across the board for the quarter, with REITs and small cap names leading the way. In a familiar refrain, growth stocks outperformed their value counterparts. Returns for growth names have been so strong that over the past ten years growth has outperformed value by over 3% annualized. However, over the past 15 years, value has provided almost 2% of outperformance above growth indices.
The US labor market continued to strengthen as employers voiced concerns about the lack of quality job applicants. However, wage growth remains elusive and consumer spending is beginning to slow. In good news for renters, there has been a large increase in multifamily inventory, slowing rent increases in major markets. The Federal Reserve raised rates in June as its primary inflation measure hit its target. In an interesting reversal, after years of hawkish positioning from Republican policy makers, Trump economic advisor Larry Kudlow warned the Federal Reserve about blunting current economic growth by raising interest rates too quickly.
First Quarter 2018: Welcome to the Job, Mr. Powell
After an unusually quiet 2017, market volatility returned in the first quarter. Strong labor and wage growth, tech stock worries, and trade war fears helped bounce equity markets up and down before ending the quarter slightly below where they started the year.
Domestically, investors fretted over a variety of new information. Increased deficit spending and rising wages raised inflation fears that sparked a selloff in Treasurys and the stock market at the end of January and into early February. In the broad-based selloff, markets fell approximately 10% from their January highs, ending a 15-month winning streak for the S&P 500. In March, President Trump raised fears of a possible trade war by unexpectedly announcing stiff tariffs on imports of steel and aluminum, making good on a key campaign promise to be tough on trade. In wake of the announcement, Gary Cohn, Trump’s top economic advisor, resigned.
Markets declined again in March, which was an especially difficult month for technology stocks. In March, it was revealed that the personal information of 50 million Facebook users was compromised without their consent, and President Trump targeted Amazon.com specifically for regulatory policy changes. Even still, growth stocks outperformed value for another quarter – the S&P 500 Growth Index returned 1.9% and the S&P 500 Value Index returned -3.6%. Smaller capitalization names also outperformed larger ones as the Russell 2000 finished the quarter down -0.1% versus -0.8% for the S&P 500. Internationally, a weaker US dollar helped support international indices as emerging markets rose 1.3%.
The yield curve flattened as new Federal Reserve Chair Jerome Powell continued with the policy normalization plan established by former Chair Janet Yellen and raised rates for the 6th time since the global financial crisis. Yields on the short-end of the curve have risen considerably since 2016, with the 2-year Treasury now yielding its highest value since August 2008. Rising rates and widening spreads pushed almost all fixed income indices lower for the quarter.
Back in 2014, we wrote a piece, Who’s Afraid of the Big Bad Rates?, which argued that long-term investors in fixed income securities should not fear rising rates.
At the time, we argued two things — first, that it is not the question of whether rates would rise, but rather the timing and pattern of their rise, that determines how harmful rising rates are to a bond investor. Second, we suggested that of all the reasons for rates to rise, investors should not fear rates rising because of Federal Reserve actions – because the gradual nature of typical Fed interest rate movements gives rise to bond returns that are essentially unaffected by the rate movement. Rising rates are a double-edged sword, slicing principal value from bonds already owned, while paying higher coupons on those not yet purchased. It is possible, we showed in 2014, that rising rates could actually turn out to be a good thing for bond investors.
While all of that logic remains true, the world for bond investors is a different one than it was four years ago. Unlike in 2014, rates are rising today, because of strong economic growth, a tight labor market, concerns for potential inflation in the future, and an articulated long-term, careful reversal of the Fed’s stimulative monetary policies that have kept rates low for the last nine years.
The world is different today, and rates are (finally) actually rising. Is it different enough that investors should now fear rising rates?
What’s to Fear?
“Aggregate” bonds are those issued by US-based investment-grade issuers, including the US Treasury, agencies, and corporations. They are intermediate-term in nature and have a current duration of 6.1 years. They are a reasonable proxy for the types of bonds typically held by many long-term investors.
For a variety of good reasons, Aggregate bonds currently yield less than their long-term average: as represented by the Bloomberg Barclays Aggregate Bond Index, Aggregate bonds currently (as of February 28, 2018) yield 3.1%, whereas since 1990, their average yield has been 4.8%. Fears of their rates rising in the future are well founded. What happens to bond portfolios if rates continue to rise?
We have modeled several scenarios for future Aggregate bond portfolio returns, given different paths of rising interest rates. In each chart below, the tan bars represent the hypothetical future yield of an Aggregate bond portfolio, and the blue line represents the growth of $100 invested in the portfolio over the next ten years. Yields are plotted on the right axis, and value of the initial $100 is plotted on the left.
It may go without saying, but it bears repeating: the expected return for a bond portfolio is its current yield. If rates do not change over the next 10 years, we expect a portfolio of Aggregate bonds to return 3.1% per year over the decade. This is the base case return, against which we can compare several alternate scenarios.
Scenario #1: Rates Gradually Rise to Their Long-term Average
The following chart depicts the value of $100 invested in an Aggregate bond portfolio over the next 10 years, if the portfolio’s yield moves from its current level, 3.1%, to its long-term average, 4.8%, in even annual increments over the next ten years.
Under this scenario, the annualized return for the decade is 2.8%, which is 0.30% per year lower than the current yield. If rates rise in this fashion, holding all else equal, investors will earn 90% of the return they would have had rates not changed at all. Hardly a disaster.
Scenario #2: Rates Rise Quickly to Their Long-Term Average
What about a scarier scenario – that instead of yields rising monotonically to the long-term average in every year, they spike immediately in the first year, returning to their long-term average, and then never change again?
This scenario is even better for the investor than the first: after a one-time drawdown, of about 7% of initial portfolio value, the bond portfolio recovers, and its total return returns to positive territory in the third year. The reason is that higher rates pay higher income – enough to offset a principal drawdown after less than two years, and in every year thereafter. The total annualized return over the decade is 3.5%, significantly higher than the portfolio’s starting yield. Far from being a scenario to fear, this is the type of rising rate scenario that long-term investors should root for.
Scenario #3: Rates Rise to Their Long-Term Average, 9 Years from Now
At the other end of the thought-experiment spectrum, we can design the opposite scenario: one where rates don’t change at all for nine years, and then spike to their long-term average in the final year:
This scenario combines the worst of both worlds – low coupon income for most of the decade, followed by a principal drawdown at its end due to the sudden rise in rates. Still, this worst case of our three scenarios results in a positive annualized return of 2.0% over the decade – a disappointing outcome relative to expectations, but far from a devastating one.
Holding all other variables constant and focusing solely on interest rate movement, these three scenarios represent bookends for future Aggregate bond returns. Under these assumptions, we cannot engineer a scenario where Aggregate bond returns will be painful over the coming decade. If we accept that interest rates are low and have potential to rise, but only as high as their long-term average, their annualized returns over the next decade will be somewhere between 2.0% and 3.5% — somewhere between 65% and 112% of the return you’d expect if rates didn’t change at all (3.1%, the current yield).
The gravitational pull of current yields is strong and nearly inescapable– it is very likely that future returns will be close to it. Any scenario less dramatic than those depicted above will result in an annualized return for Aggregate bonds, all else equal, closer to their current yield of 3.1%.
What Would It Take To See Negative Returns?
We have seen that it is very difficult to engineer a path of rising interest rates that would generate disappointing returns, as long as we assume that rates will rise no farther than their long-term average.
But what if we relax that latter assumption? It is possible, after all, that a regime change for bond yields lies just over the horizon, and that an extended period of below-average rates will be followed by a period of above-average rates.
How high would rates have to rise to generate zero bond returns for an investor, over a 10-year period? A scenario where rates don’t change for 9 years, and then rise by 4.5% in the final year of the decade, would do it:
So would a scenario where bond yields rise every year by 1.85% — for a total of 18.5 percentage points over a 10-year period (from a yield of 3.1% to a yield of 21.6%):
This is what it would take for Aggregate bonds to deliver a flat return over the next ten years: either rates need to gradually rise to historically unprecedented levels (the highest recorded yield for the Bloomberg Barclays Aggregate Index was 15.4%, in 1981) or yields need to actually not rise at all anytime soon, until they more than double in a single year, nine years from now. How likely are these scenarios?
If these scenarios are unlikely, any predictions for a meaningfully negative Aggregate bond returns over the next ten years are downright outlandish. These “disappointing” returns we have constructed are merely 0% annualized returns over a 10-year period. It would take significantly more heroic assumptions to forecast meaningfully negative returns for Aggregate bonds. As well, any such scenario we could design would build in such high yields at the end of the 10-year period that subsequent bond returns would be phenomenal, benefiting from very high yields (coupon payments) at the end of our ten-year forecast period and the beginning of the next. Under this extremely unlikely scenario, any loss in the coming decade would be quickly recovered shortly thereafter.
Nothing to Fear but Fear Itself
All of our modeling has made a critical assumption that investors are long-term investors, with relevant investment horizons of at least a decade. We are comfortable making this assumption because investors with shorter horizons than a decade probably should not have all of their bond investments in Aggregate bonds anyway. Investors with shorter horizons should own shorter bonds, which are less exposed to interest rate movements. Investment horizon is among the most relevant questions to ask when designing a portfolio.
Over long enough horizons, most risks melt away, and interest rate (duration) risk is no exception. The ability to ignore short-term market forces is one distinct advantage of being a long-term investor. Most of the damage that an intermediate duration bond investor can suffer from a rapid rise in interest rates is a result of either choosing to or being forced to sell shortly after a significant rise in interest rates. If an investor can hold onto the bonds for the longer term, higher coupons will recover the early losses over time – but only if the investor doesn’t sell them first.
We caution any investor against the temptation to modify a long-term portfolio away from its optimal allocation, which should ideally be designed specifically for that investor and its unique circumstances, in response to predictions for short-term market forces. This includes any predictions for the direction of interest rates. All forecasts, including those for interest rate direction, are unreliable. Even the US government hasn’t demonstrated any ability to forecast US government bond interest rates.
Equally, we maintain ourselves, and counsel our clients to maintain, humility in the investment process. While it’s always possible that this time is different, and interest rates could go from 3% to 21% over the next decade, it is very unlikely. It would take an unprecedented circumstance for a bond investor to experience a truly disappointing return. While every risk is worth hedging, very unlikely risks are worth hedging only at the margin, not by dramatically changing either the size or composition of a bond allocation within a diversified portfolio.
Finally, we encourage all investors to do the math. The above modeling is available to anyone with a finance textbook and a calculator. We did not invent it. Every scenario we have modeled acknowledges a possibility for higher rates – in fact, every scenario assumes rising rates. But assuming rising rates is not enough – the path and magnitude of the rising rates are much more consequential than a prediction of whether they will rise. The above analysis shows that some reasonably likely scenarios for rising rates actually benefit the investor.
Ultimately, when we look at bonds, it is difficult for us to see a scenario where long-term investors will be disappointed relative to reasonable expectations – you have to torture the data pretty thoroughly to get it to confess to prospects for disappointing return. Very few portfolios are made up entirely of bonds. They typically exist in a portfolio to offset other risks – mainly, those delivered by equities. This important portfolio role for bonds is far from nullified in the face of prospects for rising rates.
Sellwood Consulting’s 2018 Capital Market Assumptions are available. These 10-year, forward-looking assumptions of asset class return, risk, and correlation are the key input variables for our asset allocation work on behalf of clients.
We update our assumptions annually. Over the course of 2017, investors’ shifting preferences away from bonds and toward risk-seeking assets caused valuations for risky assets to expand, fixed income spreads to tighten, and yields for shorter-term Treasury bonds to rise. Updating our assumptions for 2018, we forecast lower returns for every equity category, and higher returns for most fixed income categories, than we did last year.
As a result of these updates, our forecasted “capital markets line,” depicting opportunities for investment return at varying levels of risk, has flattened: we believe that over the next ten years, investors will not be as compensated for taking risk as they have been in the past. In the case of fixed income, higher real yields bring greater opportunity for return with lower risk. For risky assets, like global equities, the market experience of 2017 brought higher valuations, which pull return from the future into the past.
Within equities, it is no coincidence that the markets that experienced the largest gains in 2017 saw the largest declines in forward-looking assumed return under our valuation-based methodology. Even after these changes, our modeling suggests that investors will be well served to diversify their equity exposure outside the United States. Emerging Markets equity remains the asset class with our highest expected return, albeit with our highest forecasted risk amongst equity categories.
Within fixed income, our analysis presumes that interest rates will rise. Consequently, we forecast that duration risk will not be compensated. We expect that nominal bonds between low and long duration will experience roughly similar returns over the next decade.
This year, we made two changes to our methodology. First, we added a short-term TIPS assumption, to go alongside the TIPS assumption that has been included in our assumption set as long as it has existed. Our methodology for this assumption is consistent with our methodology for all other fixed income assumptions. Second, we improved the methodology that we use to forecast US small-cap returns. Details can be found in our white paper. All other changes to our assumptions simply reflect new information that the market provided us in 2017.
Loathe as we are to give any thought to short-term returns, the recent market correction has been interesting.
The S&P 500 index peaked on January 26, before dropping approximately 2% over the next few trading sessions, and then dropping more precipitously during the week of February 5. On February 8, the market had declined by 10%, officially a “correction” (it has since recovered a portion of these losses).
How bad was it?
While never comfortable, market corrections are common, and the recent 10% market decline was not historically unusual.
Since 1949, there have been 34 double-digit drawdowns in the US stock market – about one every other year, on average. Over the same period, the average magnitude of a market correction has been 15%. Over a longer history, since 1900, the Dow Jones Industrial Average has declined by 10% or more about once per year, on average.
Even in the current post-2008 market cycle, the US stock market has declined by double digits five times. US stocks fell 16% in 2010 over fears of a double-dip recession, and they declined by nearly 20% in 2011 during the European debt crisis. 2015 and 2016 saw corrections of 12% and 14% after a global growth scare and fears of a hard landing of the Chinese economy.
What caused this correction?
Nobody knows for sure, but that hasn’t stopped everyone from having an opinion. One interesting thing about markets is that the return experience drives the narrative. Several narratives have emerged, each of which is plausible:
- Rising rates: Real interest rates on government bonds have been rising since early September. Higher interest rates make future cash flows worth less today, sending stock and bond prices lower.
- Inflation concerns: On February 2, the government’s non-farm payroll report showed signs of wage growth, which suggests higher inflation in the future. Higher expected inflation implies that the Federal Reserve, especially with a new Chair, will raise interest rates more quickly than had previously been anticipated.
- Mean reversion: The S&P 500 index rose by nearly 6% in the month of January. Because broad stock market averages don’t rise by 70% a year, something had to change.
- Human emotion: Market participants, being human, wanted an excuse to sell and take profits. A market drop of uncommon (in recent memory) magnitude provided the reason.
- Robots: High-frequency trading, algorithms, and risk parity strategies have been blamed by some observers, although there is not consensus on whether these strategies represent enough of the market to have caused the correction.
- Valuations: In January, the two-year Treasury bond yielded more than the S&P 500 did.
- Fiscal (over)stimulus: In the face of historically low unemployment and stable economic growth, the recent adopted corporate tax cuts and proposed federal infrastructure spending initially poured high octane fuel into the economic engine. Subsequent realization that burgeoning deficits and rising inflation could disrupt the economic engine sparked a sell-off.
- Optimism: It is said that “markets climb a wall of worry.” The tremendous market gains since March of 2009 came during a period when most of the news about, and public analysis of, the market was negative and discouraging. With the benefit of hindsight, we can look back and see that economic fundamentals were steadily improving over these past nine years, but in the moment, that steady growth was obscured by dramatic negative events and headlines. By the end of 2017, all the headlines had turned positive – a survey of small business optimism was the highest it had been since 1980, consumer confidence readings were their highest since the mid-1990s, US unemployment was lower than at any time since 1999, and even wage growth was finally appearing. By January 2018, the wall of worry had crumbled, and the stock market, having reached its summit, responded to the law of gravity.
- Random chance: The 10-day market return was well within a normal distribution of short-term returns, and a reminder that returns are compensation for bearing risk.
Or some combination of the above. In the end, nobody knows, and it doesn’t really matter. Markets experience corrections of similar magnitude in most years. Explanatory narratives always emerge after the fact, but they don’t change the fact that markets don’t necessarily need a reason to correct. Just as trees do not grow perfectly vertically, markets never rise without interruption. Corrections are a normal feature of markets.
Nowhere to hide
What is more interesting to us is how diversified portfolios held up in the market correction – which is to say, not very well.
From peak to trough (January 29 – February 8), markets saw the following returns:
- US large-cap stocks (S&P 500): -10.1%
- International stocks (MSCI ACWI ex US IMI): -7.8%
- US REITs (Wilshire US REIT): -9.1%
- Commodities (Bloomberg Commodity): -4.1%
- Intermediate-term high-quality bonds (Bloomberg Barclays Aggregate): -1.0%
- Long-term high-quality bonds (Bloomberg Barclays US Gov’t/Credit Long): -3.2%
- Trend following strategies (Credit Suisse Managed Futures): -8.9%
- US Treasury Inflation-Protected Securities (Bloomberg Barclays US TIPS): -1.1%
- US short-term TIPS (Bloomberg Barclays US TIPS 0-5 Years): -0.3%
- US Cash (US T-Bill): 0.10%
This correction was unique in that diversification did not appear to help. Assets that traditionally have offset market declines, like long-term bonds and trend following strategies, suffered negative returns along with equities. Although correlations between assets typically rise in times of market stress, risk-hedging assets have often been exempt from this phenomenon. In this recent correction, they declined as well, because the scare that affected equities – concerns for higher inflation and real interest rates – is bad for both bonds and stocks. Even assets designed to protect against changes in inflation expectations – TIPS – declined, because one component of their return is that of a Treasury bond.
Onward, With Caution
In a sense, market corrections are a gift: they provide risk, without which there would be no return.
The correction is a reminder that the only market history worth paying attention to is its long-term history. Prior to this most recent correction, the S&P 500 had experienced 404 consecutive trading days without a 5% drawdown, the longest such streak since 1959. An evaluation of the market only since January of 2016 would suggest an environment of return without risk, against a backdrop of global economic stability and a very low volatility. Complacency is a risk to investment decision-making in this sort of environment.
Moreover, we believe that a long-term perspective is equally valuable when assessing the merits of diversification. While all data points are valuable, diversification cannot be judged by how it performs in any ten-day period.
Finally, as much as the world is driven by computers and machines, markets are still moved by human beings. Humans overreact to new information, become overly exuberant when prices rise, and unreasonably panic when prices decline. The rational response to this scenario is to maintain calm and discipline – to be more robotic. Disciplined portfolios, including periodic rebalancing strategies, take advantage of market corrections by buying at lower prices.
There is no return without risk. Until three weeks ago, this notion may have seemed passé. The recent market correction suggests that the laws of finance have not in fact been repealed. A proper long-term perspective suggests that market corrections like the one we just experienced are normal features of risky markets.
Steep declines are much more likely in shorter periods than longer periods. A 10% drawdown inside a calendar year is relatively common, but a 10% drawdown over several years is very unlikely. Whether a 10% market correction is consequential to an investor depends entirely on the investor’s investment horizon. For any true long-term investor, over time, market corrections fade into irrelevance as signal overwhelms noise and distributions of return narrow. For investors with shorter horizons, the correction is a reminder that stocks are less suitable components of a portfolio and should be approached with appropriate caution and portfolio sizing.