Since the minor turbulence we experienced after Britain abruptly decided to leave the European Union, the markets were quite calm this summer. The S&P 500 is up 5.67% year to date, and even went over 50 consecutive trading sessions without a decline of more than 1%.
Central banks around the world continue to print money with reckless abandon, with five major economies employing negative interest rate policies in an attempt to boost their output. Fixed income assets like investment grade corporate and high yield bonds contain a great deal of risk in exchange for marginal (at best) potential returns. Capital markets around the world are certainly at a precarious point.
But even if we can identify risks of investing in certain asset classes, or think the stock market’s overdue for a correction, or even believe we’re in the biggest bond bubble of all time, it’s important to remember that the most successful investment strategies will adhere to a long term, strategic asset allocation.
Over the last few months, I’ve heard from several people who are waiting for the perfect time to invest. They’re waiting for stocks to fall so they can pick them up at lower prices, or waiting to see what will happen after the next Federal Reserve meeting. This is a mistake, in my opinion. Study after study tells us that it doesn’t matter when we’re in the markets, it only matters how long we’re in the markets.
I believe it’s important to keep close track of what’s happening in the markets and global economy, but don’t let this news or analysis distract you. The path to successful investing is through a long term and consistent strategy.
All in all, the U.S. economy is on solid footing and is still gaining ground. The theme that will have the biggest effect on your portfolio is the timing of interest rate increases by the Federal Reserve Bank. Interest rate increases have the potential to derail the bull market we’re currently in, and will depend on how well the economy is growing and whether inflation becomes a problem.
The most recent Fed meeting occurred last week, when the Federal Open Market Committee (FOMC) decided to leave interest rates unchanged. This decision was not a surprise. Comments from Fed chair Janet Yellen convey confidence in the economy, and the decision not to raise rates was made in order to “err on the side of caution.” With inflation under control, the risk that an interest rate hike would smother economic growth was too great.
This decision was not unanimous. Three officials voted to raise rates, which is the most dissents of the six FOMC meetings held this year. All things considered, it seems likely that we’ll see a hike in the December meeting.
Another interesting result of the Fed meeting was that it lowered its forecast for 2016 GDP growth for the third time this year, from 2% to 1.8%. This isn’t quite an indication of a downward trend, though. The revision was partially caused by a decrease in year over year housing starts in August. Groundbreaking decreased 5.8% after two straight months of strong gains.
Most of this drop can be attributed to flooding issues in Louisiana, as single family housing starts in the south (which account for the bulk of all home building) fell 13.1% year over year. For this reason the Fed’s downward revision shouldn’t set off any alarms for long term economic growth in 2017 and beyond.
The labor market across the country is pretty healthy right now. The unemployment rate currently sits at 4.9%, which is certainly on the lower end of the spectrum. Typically, when the unemployment rate sits so low job growth starts to slow. This is mainly because there are fewer qualified workers to fill open positions.
Despite the low unemployment rate, we haven’t seen much wage growth in recent months. Average hourly earnings growth slowed to 2.4% year over year in August from 2.6% in 2015. Even so, the workforce is finding a way to make up the difference, perhaps by working more hours. The U.S. Census Bureau recently reported that median incomes in the U.S. rose from $53,718 to $56,516, an increase of over 5%. This is a large jump. In fact, it’s the largest since the Census Bureau started tracking the metric in 1967.
The Bank of Japan also made headlines last week when it announced it would be pivoting the focus of its monetary policy. For many years, Japan has attempted to stimulate its economy with a regime of ultra-low interest rates. This is a common tactic by central banks around the world today, but Japan was the first to try it so aggressively.
Japan first lowered interest its benchmark interest rate to near 0% in 2001. The idea was that with rates so low, banks would be incentivized to lend money rather than hold it, which would stimulate the economy.
The strategy took longer to work than expected. And with interest rates already reduced to 0%, the Bank of Japan was out of room to move them any lower. So to accelerate the process, the Bank started buying up Japanese assets like government issued bonds, real estate, and stocks. This was the first ever attempt at “quantitative easing”, which so many central banks around the world have since tried.
Since the financial crisis, the Bank of Japan has expanded its program of quantitative easing several times. And up until recently, the bank’s focus has been to continue injecting cash and “print its way out of trouble.”
Last week, the Bank of Japan announced it was changing course. Rather than focusing on widening its monetary base, the bank will now hold the rates of its 10-year government backed bonds at 0%. This is an interesting move, since it’s almost a concession that the bank’s ultra-aggressive asset buying strategy didn’t work.
It also gives credence to the viewpoint that the Bank of Japan couldn’t continue its aggressive easing policy forever. Right now the BoJ owns about 40% of all Japanese government debt. Eventually, the bank would have run out of bonds to buy. Whether this shift helps boost Japan out of its economic rut remains to be seen. But either way, other central banks around the world are keeping a close watch.
Volatility in U.S. stocks has been far lower than investors expected, as the markets have been rather dormant since the early summer. The S&P 500 lost 2.5% on September 9th, which was the first time it had seen a decline over 1% since June.
As we proceed toward the end of the year it’s important to not get complacent. Stocks of all cap sizes are still on the higher end of the spectrum in terms of valuations. The S&P 500 is currently trading at 24.81 times the last 12 months’ worth of earnings, compared to 20.59 a year ago and a historical average of 15.62. This is a significant multiple expansion (over 20%) in just the last 12 months.
Beyond valuations, corporate profit margins are on the decline as well. Profit margins are often used as a cyclical indicator of the business cycle. When times are good, margins are high. And when the economy contracts in a recession, profit margins bottom out.
The chart below comes from data released by the Federal Reserve Bank of St. Louis, and shows corporate profit margins after tax as a percentage of GDP. Notice that the three vertical arrows point out the last three recessions we’ve had in the U.S. The triangles represent the peak corporate profit margins during the headiest portion of the business cycle, and the diagonal arrow shows the current trend we’re on.
You can see that since 2009 profit margins have rebounded drastically. But, we may have already seen the peak of this business cycle back in 2012. Profit margins as a percentage of GDP have steadily fallen since then, which is not a good sign for stocks.
This data is not a prediction that another recession is on the horizon, or that the market is about to correct. Instead, we should view this as a headwind for equities. The economy is still chugging along just fine, and the bull market may still have a long way to run. Just keep in mind that margins are more likely to shrink than expand, and large stocks are more expensive than they are cheap. As this business cycle ages, future gains in equities will need to come from top line revenue growth. Suffice it to say that the best investment opportunities for this cycle are probably behind us.
High Yield Bonds
With interest rates remaining at depressed levels, investors across the world have worked hard to generate yield wherever they can find it. Many have resorted to taking additional credit risk in the high yield bond sector.
Since 2008 this strategy has worked pretty well. The S&P U.S. Issued High Yield Corporate Bond Index has returned an average of 10.22% per year, while the S&P U.S. Issued Investment Grade Corporate Bond Index has returned an average of 7.62%. These are large returns for bonds, but not unprecedented during an economic expansion. High yield bonds tend to perform just fine during expansionary periods after financial crises. But when the tide turns and the next recession hits, they’re also the first to struggle.
Today, high yield bonds appear expensive. One way to measure value in the bond sector is to examine yield in excess of what you’d get from a risk-free U.S. treasury bond. This concept is known as “spread.” Historically, investment grade corporate bonds have a long term average yield spread of about 1.5% over U.S. treasuries. Since high yield bonds contain more credit risk, their spread over treasuries is higher: about 5.5% on average, over the long term. When these yield spreads are higher than their long term averages, the asset classes tend to be undervalued. When they’re lower than average, they’re often considered overvalued, since you don’t get as much return in exchange for taking the same amount of risk.
Right now investment grade corporate bonds yield 1.4% more than comparable U.S. treasuries, indicating they may be slightly overvalued. High yield bonds yield 5.0% more than treasuries - a good deal less than their long run average, meaning they could be significantly overvalued.
Additionally, the high yield sector is becoming more leveraged, which increases the risk to the already high risk asset class.
Debt service to EBITDA is a common way to compare the leverage of various companies or asset classes. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and is a pretty good proxy for cash. The more cash a company must use each month to service its debt, the more risky an investment that debt is. If something goes wrong, the company has less margin for error.
The data from the chart shows that the difference in this metric between investment grade and high yield bonds has grown since 2008. High yield bonds have become more risky, both on their own and when compared to corporate bonds. And with the spread over treasuries below its long term average, high yield bonds are becoming more risky at the same time the return for taking that risk is falling.
These data points lead us to the conclusion that the risk/return proposition in high yield bonds is not in our favor right now – especially when compared to investment grade corporate bonds and U.S. treasuries. Note that this has nothing to with duration (the risk that bond values will fall when interest rates rise), which is an entirely different conversion. If you’re concerned that our country’s strategy of low interest rates has created a bond bubble, you should be really concerned of what that might mean for high yield bonds.
While high yield bonds may not offer much return in exchange for the risk involved, bank loans are an asset class that’s more appealing. Bank loans are syndicated loans made to below investment grade companies, which are also known as leveraged, or senior loans. They are not quite as risky as high yield bonds, though. Bank loans are usually senior debts, meaning that if the company faces bankruptcy they’re one of the first debts to be repaid. They are also normally backed by collateral.
Perhaps the most attractive feature about bank loans is that they’re issued at floating interest rates, making them useful in rising rate environments. The interest rate is based on a spread above LIBOR or the Prime rate, and depends on how credit worthy the borrower is. As LIBOR/Prime change, so does the interest rate on a bank loan. Because of this, bank loans have far less duration risk than traditional fixed rate bonds.
Right now, bank loans yield 5% on average. This is an attractive return, but keep in mind that underlying loans in bank loan funds are typically illiquid, which does add to their risk.
The price of oil is on the rise again, thanks to tightening in world markets for the commodity. Morningstar, the financial company famous for its mutual fund grading system, was surprised enough by an increase in global demand to bump up their price estimates through 2020:
In publishing the revision, Morningstar noted that economic turmoil in both Venezuela and Nigeria is putting a dent in production numbers, as major facilities in both countries remain offline.
Venezuela is going through a horrific financial crisis. The country is battling massive food shortages and hyperinflation of its currency, which is likely to cause its economy to shrink up to 10% this year. As you might expect, this is a huge setback for capital investment, which has a large impact of the country’s ability to finance oil production. In short, Venezuela can’t afford to drill right now.
In Nigeria, militants continue to attack oil pipelines and production facilities, forcing many operations to temporarily shut down.
Since early in 2014 when oil fell from $100 per barrel, the market has been constantly oversupplied. But rather than bring the extra oil to market and sell it at depressed prices, most producers opted to warehouse it and wait until the market improved. Before we see a precipitous rise in price, the market will need to work through these extra stockpiles.
The production cuts in Nigeria and Venezuela are a good opportunity to do so. Combined, the two countries account for about 5% of the world’s oil production, and some analysts predict that that with their facilities offline, we could work through the excess supply by the end of 2017. Whereas WTI crude oil currently trades at about $45 per barrel, this may lead to an increase of over 30% to $60 per barrel in just a few short years.