Despite the headlines, ruffled feathers, and self-aggrandizing tweets, stock markets have marched upward very consistently since Mr. Trump took office this year. Interest rates on both ends of the yield curve continue to tick higher, and equities in the international and emerging markets have also been strong. At this point, we need to prepare for the inevitable time when the levy breaks. U.S. stock markets are quite expensive on a historical basis, and our current 10-year bull run is one of the longer growth cycles in history.
While I never advocate for investors to time the markets, or change course because they expect a market downturn, we do need to understand that this level of calm is not the norm. I can’t tell you when or how the next market crash will occur, only that it will happen eventually. To prepare, investors should ensure that their strategic asset allocation fits their objectives and comfort with risk like a glove. If you’re uncomfortable with the idea of a stock market crash, it’s probably time to reassess your portfolio.
U.S. Economy & Government Bonds
The Federal Reserve Bank decided to raise short term interest rates again on March 15th, to a range of 0.75%-1.00%. The move was widely telegraphed and expected by the markets. Moving forward, Fed chair Janet Yellen expects two more increases later this year, in June and December.
Yellen has a strong argument justifying the rate increases: the economy is doing quite well. GDP growth is expected to be 2.1% in both 2017 and 2018. Inflation is trending up towards the Fed’s long term target of 2% as well, coming in at 1.9% annually in the most recent measure.
In plain English, this is all good news. The economy is expanding at a strong but steady pace and doesn’t appear to be overheating. Inflation and prices are under control. Corporate earnings growth is strong, and unemployment is down to 4.7%. And by raising rates now, the Fed is essentially adding arrows to its quiver. Whenever the next downturn does occur, the ability to change course and reduce rates again without bumping up against the 0% floor will be very convenient.
So, regarding monetary policy controlled by the Federal Reserve (using short term interest rates and other levers to control the money supply) all is calm on the western front. However, monetary policy is only half the story. Fiscal policy is the complementary factor to our national economic strength. This sister strategy mostly concerns the amount of government spending and our aggregate tax burden, which is largely driven by our president.
Obviously, our current president believes in a smaller size of government. Mr. Trump is attempting to foster a business friendly environment with lower taxes and fewer regulations. Despite strong (and still improving) economic growth, the way Mr. Trump’s fiscal policy plays out remains a big wild card. He’s had an eventful few months in office, and his tax plan has not yet reached the “front burner.”
The chart above shows the current yield levels on U.S. government bonds across varying maturities. This chart uses the current yields of “on the run” treasuries, meaning they’re the most recent securities issued by the government directly to the investing public.
Notice that the yield curve is upward sloping. Whereas very short term interest rates are set by the Federal Reserve (as an extension of the bank’s monetary policy),
longer term rates depend more on market forces. When Mr. Trump was elected to office in November, long term rates spiked. The widespread interpretation is that the markets expect Mr. Trump’s potential tax cut (his fiscal policy) to boost growth, and eventually lead to inflationary pressures down the road.
For investors, it’s an important time to understand the duration risk contained in your bond holdings. When interest rates increase, the market prices of bonds fall. If Mr. Trump continues down the path he promised in his campaign, the current upward trajectory will probably continue. This is a risk for long term bondholders.
U.S. Corporate & High Yield Bonds
Aside from the trajectory of rates on U.S. government bonds, another question many bond investors are asking is why corporate bond yields are still so low. If long term rates on government bonds are rising, shouldn’t corporate bonds move in lockstep? The answer isn’t so clear cut.
Returns in riskier fixed income categories, like high yield bonds, have been extremely strong over the last year. In fact, some high yield bond indices have increased more than 17%. As we touched on in the previous section, earnings growth from U.S. corporations is strong. Additionally, default rates of high yield debt are down from 5.1% in December to 4.4% in February. Both these metrics point to an improving business climate.
With more favorable conditions, investors have become more comfortable “stepping out on the curve” and taking on more risk in their bond portfolios. This higher demand for corporate and high yield bonds has driven prices up over the last year or so. And as we covered above, when bond prices increase, bond yields decrease, and vice versa.
In other words, even though long term interest rates have increased in general, the high demand from investors has kept downward pressure on corporate bond yields.
One way that we measure & track changes in the corporate bond market is by assessing the credit spread over U.S. treasuries. Simply put, credit spread is the extra yield an investor receives by lending money to a borrower less credit worthy than the United States government.
For example, a 10-year U.S. government bond contains hardly any credit risk. Since the bond is backed by the full faith and credit of the U.S. government, there’s an extremely low likelihood of default. On the other hand, a corporation has a higher chance of going broke. The extra return a bond investor receives for taking this risk is known as the credit spread.
As you can see, credit spreads have narrowed over the last 12 months. The explanation here is that the potential for a more business friendly environment, complete with lower taxes and fewer regulations, has caused an increase in demand for corporate bonds. So, even though longer term rates are going up, the extra demand is holding corporate rates down.
Domestic stocks are off to another strong start, for many of the same reasons that longer-term interest rates are increasing. In general, stock markets like the idea of lower taxes – even if they’re unsure about when or how the concept might play out. Year to date the S&P 500 is up nearly 5%. The Russell 2000 small cap index is not far behind, gaining 2.3% thus far in 2017.
I often speak with people who lost a great portion of their portfolio between 2007 and 2009, and are fearful that we’re overdue for another catastrophe. While I agree that this bull market is probably little “long in the tooth,” the bounce back since 2009 has truly been ferocious. The charts below show the performance of the S&P 500 large cap index, and Russell 2000 small cap index over 1-year, 3-year, 5-year, and 10-year periods. Note that the 10-year period brings us back to March of 2007, just before everything started to go south.
Looking at the cumulative returns chart, the both indexes have gained over 100% since March of 2007. This means that investors who’d stayed put throughout the depths of the crisis and simply “stuck with it,” would have gained about 7.5% per year on average. This pretty closely resembles the long-term average market returns. It’s also a testament to the long term buy and hold investment philosophy.
If you couldn’t already tell, my comments above are partially meant to prepare you for the next major market swing. A ten-year bull market is on the very long end of the spectrum. Again: I don’t pretend to know when or why the stock and/or bond markets might correct next, but I do know that at some point they will.
Aside from the sheer length of the current bull market, the S&P 500 appears to be quite expensive based on relative valuation metrics. Since 1871, the index’s month over month average P/E ratio is 15.64. Currently this number sits 57% higher, at 24.49. If we were to rank the index’s P/E ratio each month since 1871, we’d currently be in the 94th percentile.
How did we get to this point? From a strong and steady march forward since 2009. Aside from a few minor blemishes and bumps in the road, the market’s rise has been extremely consistent. The VIX index measures the market’s volatility, and spikes when the market crashes. Note the high point in the chart below, in early 2009.
The chart also tells us what we already know – things have been eerily calm over the last several years. We had a blip when Britain decided to leave the EU last year, and another in August of 2015. But more recently, nothing seems capable of derailing or even phasing the market. North Korea is launching missiles, the Federal Reserve is raising interest rates, and political infighting both here and abroad seems endless. But despite all this, the market hasn’t seen a down day of over 1% since October 11th of 2016!
Could this be the calm before the storm? The valuation numbers say that the next five years of market returns will probably be lower than the last five years. But if corporate earnings growth continues hold pace, we may still be a few years off from a significant correction or crash.
Stocks have posted solid gains outside the U.S. too, in both developed and emerging markets. The MSCI EAFE index, representing stocks in developed economies, and MSCI Emerging Markets index are up 5.99% and 12.14% thus far in 2017. In the last 12 months, the indexes have gained 12.14% and 16.4%, respectively.
The theme in 2016 was populist sentiment arising in Europe. Populism has to do with the interests of ordinary people. With the massive exodus from Middle Eastern countries like Syria and Afghanistan over the last few years, this idea has become a key economic influence in Europe. Across the continent, a nationalistic mentality started to spread as hundreds of thousands sought refuge in 2016. With the influx of immigrants, Europeans became less concerned about the greater European Union and more concerned about their home countries. This is one of the factors that led to Britain’s decision to leave the European Union.
One risk we discussed in prior market updates is that this sentiment will continue to spread, forcing a breakup of the European Union (EU). The theory is that if the EU broke up, significant trade barriers would arise between countries, causing economic growth to suffer.
This risk seems to have abated. The immigration issue seems to be fueling much of the populism sentiment, and the number of asylum seekers has dropped significantly in the EU thus far in 2017. At the high point, 170,000 people per month sought asylum in the EU. This number has fallen below 75,000 people per month.
With fewer people fleeing the Middle East for better lives in Europe, the populist momentum may fizzle. Leaving the EU is a somewhat radical idea, and now that immigration has tapered off it seems like populists are starting to back off the ledge. The Netherlands just held a general election on March 15th. The “Party for Freedom”, representing populism, ran on the platform of leaving the EU and halting immigration. The party led for much of the race, but ultimately lost the election handily. There are more elections and referendums later in 2017, including France in April & May and Germany in September. But at this point, the chance of a surprise vote to leave the EU is very low.
Elsewhere, China finds itself in a tight spot now that the U.S. is raising rates. The People’s Bank of China (China’s equivalent of the Federal Reserve Bank) has for years supported China’s currency, the yuan. By keeping rates higher than the U.S. and elsewhere in the world, China has encouraged capital inflows and foreign investment.
With the U.S. raising interest rates, China has pressure to follow suit. If they don’t, they risk an outflow of capital from China back to the U.S. But if they do, they risk stifling the economy with expensive borrowing costs. The government has already started to reduce spending on infrastructure, setting the country up for a potential double whammy.
Thus far, the reduction in Chinese government spending has been backfilled by an increase in private sector construction. Private construction is particularly
sensitive to interest rates, leaving the People’s Bank of China at quite the crossroad. The bank will need to navigate its positioning alongside the U.S. carefully. If it doesn’t, it’s economic growth could sputter, which would certainly cause volatility to ripple across the globe once again.
Closed-End Mutual Funds
Closed end funds are professionally managed mutual funds, but are closed to additional investment. In a traditional mutual fund, an investment manager accepts new cash from investors and issues shares of their fund in exchange. In effect, investors transact directly with the mutual fund management company. When a mutual fund closes, the manager stops accepting new cash investments. Investors are instead left to purchase shares in the secondary market from other investors.
Some closed end funds are leveraged, and borrow money for short periods of time to invest the proceeds in longer dated bonds. Normally closed end funds will borrow money at lower rates, lend at higher rates, and profit from the spread. This strategy works well when the yield curve is upward sloping and long term rates are higher than short term rates (as it is now). When the yield curve flattens, the difference between long term rates and short term rates becomes smaller. This tends to harm closed end mutual funds. Since funds typically borrow at shorter term rates, their borrowing costs increase whenever the Federal Reserve decides to raise rates.
We currently have an upward sloping yield curve, but it’s clear that as long as the economy behaves, short term rates will continue to rise. This has the potential derail returns from closed end funds. While it’s very possible longer term rates will continue to increase too (preserving spread) we’ve already seen corporate bond yields depressed, which we discussed above. Investors in closed end funds should be aware that a flatter yield curve is possible, which could drive returns on closed end funds negative.