Weekly Commentary

As of Friday, November 18th, 2016

Lions and Tigers and (Bonds), Oh My!

SUMMARY

Equity markets were mixed this week with domestic stocks (S&P 500) up 0.96% and international (EAFE) stocks down -1.49%
Fixed income markets saw a divergence with investment grade bonds down -0.81% and high yield bonds up 1.39%
One and Done? – this week St. Louis Fed President James Bullard indicated that the Fed may only need “a single policy-rate increase” to move monetary policy to a neutral setting. Markets had begun to price in a slightly higher trajectory of rate increases. In other statements Yellen said an interest-rate hike could come “relatively soon” and that the economy “will warrant only gradual increases in the federal funds rate over time to achieve and maintain maximum employment and price stability.” All signs now point to an imminent rate hike in December.
ECB – European Bank President Mario Draghi sent a strong signal this week that the bank will extend its stimulus measures at next month’s meeting, stating “We cannot yet drop our guard.”
U.S. Dollar – the dollar index hit is highest level since 2003 this week and will be an even more important macro catalyst to watch over the near-term.
Commentary: This last week brought volatility to both the stock and bond markets, but the biggest “wild animal” that grabbed investors’ attention was the topic of the bond markets. Let’s dive into what happened, why, and why the truth is once again deeper than the headlines in order to find the opportunities that exist.

MARKET RECAP

THE FACTS

Positive data this week included:

Earnings Season – as we believed would happen the corporate earnings recession is finally over, with corporate America on pace for over a 4% earnings increase year over year (over 7% excluding the energy sector).
Retail Sales – the uncertainty around the election did nothing to slow down the consumer with the latest report showing exceptionally strong 4.3% gains year over year. The strength was both across the board and on top of upwardly revised numbers for September as well. It appears the strength in the labor market is having a positive effect on the consumer.
U.S. Manufacturing - the Empire State index, a measure of manufacturing sentiment in New York and respected proxy for the broader market, jumped to +1.5 in November from -6.8 in October, as new orders and shipments surged.
Japanese Growth – beat expectations for the third-quarter up an annualized 2.2% on strong exports, but with weak domestic activity its sustainability is in question.
Jobless Claims – Initial claims fell by 19,000 for a total of 235,000, sinking to a 43 year low. Continuing claims also decreased by 66,000 last week for a total of 1.98 million, marking the first time they have dropped below 2 million since the mid-2000s.
New Homes – Construction on new homes surged almost 26% in October to a nine year high. The rebound from September was led by a spike in multifamily units with construction on apartments and condos up 75%. New permits are also up 5% year over year, suggesting that future demand continues to strengthen and home builders will continue to ramp up construction.
U.K. Retail – Retail sales in the United Kingdom surprised to the upside last month with the volume of goods sold in stores and online jumping 1.9%, far better than expectations of around 0.5%. It is noteworthy that this strength comes along side U.K unemployment hitting an 11 year low.
China – Updated figures this week indicate the Chinese economy is not losing any steam in their pursuit of expanding the economy. Last month industrial production rose 6.1%, retail sales grew 10.1%, and bond investment added 8.3% as domestic drivers are easing concerns over the possible impact a Trump presidency will have on their economy.

Disappointing data this week included:

Mortgage Applications – were down sharply on rising mortgage interest rates, falling to their lowest level in almost a year. Though some of the weakness is likely also attributable to the build-up to the election.
Industrial Production – Production came in slightly weaker than expected in October with no change seen month over month, lower than consensus expectations of around 0.1-0.2% improvement. The result was largely driven by a weakness in utilities output dropping 2.6%, largely a result of the nation’s unseasonably warm weather.

Our Take

The collective markets over the last two weeks have been something to behold with significant volatility to both the up and downside across asset classes. The Dow Jones and its 30 stocks hit an all-time high, while the former tech darlings that make up the NASDAQ took quite a hit. Bond markets booked losses across the board, despite some important differences that were seemingly forgotten and international equities have struggled supposedly because of renewed strength in the U.S. dollar.

Whew!

So what to make of all this. If I learned one thing in over 20 years of investing and managing money it is not to immediately react to inputs that are this inconsistent and in many cases contradictory. That said, these types of markets are exciting. When overreactions abound, either positive or negative, active management has the chance to uncover exciting opportunities. In talks with various fund managers this week, this is exactly what they are feeling as well.

While they are focused on individual stock and bond opportunities for our clients, we are looking for longer-term allocation changes to position portfolios moving forward. These include new segments of the U.S. market, more credit oriented segments of the fixed income market, and despite its now quite prolonged dormancy we believe there is great value to be found overseas.

As Alliance Bernstein recently commented regarding international equity markets, “Our research shows that a falling proportion of the share-price volatility is attributable to company-specific issues such as operating fundamentals, management behavior, or equity and debt issuance trends (Display). At the same time, more and more stocks in the market are finding their valuations compressed because of their exposure to market beta or macroeconomic uncertainty.” Put another way, there are great companies and values that should do very well for patient investors once the general market negativity begins to subside—and as we saw last week sentiment can shift suddenly and unexpectedly.

In summary, the Fed is pulling back, economic sentiment and corporate earnings are improving, the retail sector is coming to life and assets classes are losing their high correlations to each other—those are positive developments for investors and active managers. Will there be more volatility? Yes, that is the reality of the information age we live in, but that volatility means opportunity too.

Commentary: Lions and Tigers and (Bonds), Oh My!

“Do you suppose we’ll meet any wild animals? … Some. Mostly lions and tigers and bears ... Oh my!” – Wizard of Oz (exchange between Dorothy and the Tin Man)

Intro

The truth is we all wish this thing called “investing” was a little easier, a little less confusing, a little less dramatic. Years (or months) like this with a number of bouts of volatility and plenty of negative headlines can tire even the most patient of investors.

The reality is that along our journey we are going to run into some markets that act a lot like “wild animals.” While the daily undulations of markets may make us feel like we aren’t making progress at times, with a little time and patience we can cover great distances.

So what do we do? Many obviously consider avoiding the journey altogether, while some believe they can “time” when the next wild animal jumps out of the woods—to that end it’s worth pointing out that most scary headlines turn out to be nothing more than another cowardly lion. The best course of action to successfully complete the journey is to decide your path, know there will be market scares to be overcome, and make the journey with friends.

This last week brought volatility to both the stock and bond (e.g. fixed income) markets, but the biggest “wild animal” that grabbed investors’ attention was the topic of the bond markets.

Let’s dive into what happened, why, and why the truth is once again deeper than the headlines.

What Happened and Why?

The move that precipitated the headlines was the 10-year Treasury’s 50 basis point (i.e. half a percent) move to over 2.3%, largely off of the beliefs that the Fed will raise rates in December and President-Elect Trump’s stimulus plans will be reflationary. For Treasuries, which are considered the risk-free rate, a move up in yields results in a direct move down in their price/value.

With the Treasury market being one of biggest single markets and types of holdings in the world, this move in rates resulted in large losses and similarly large panic for their investors (particularly pensions and sovereign wealth funds).

However, this correlation between rates and Treasuries is not necessarily the case for other types of bonds. For example, last week while Treasuries declined by almost 2%, both many floating rate loans and high-yield bonds were unchanged.

Unlike James, in Fixed Income There Isn’t Just One “Bond”

Most investors are understandably confused by the bond markets. When headlines or pundits on TV mention “bonds” they are almost always referring to the 10-year U.S. Treasury market, but they rarely bother to differentiate or note that fact. As a consequence, investors assume all bonds are, and/or act, the same.

This is not the case.

There may be only one James Bond, but bonds are most analogous to the number of types of shrimp Bubba taught us about in Forrest Gump.

There’s government bonds, inflation protected bonds, municipal bonds, agency bonds, mortgage bonds, corporate bonds (including all the different types of sectors of corporate bonds), floating rate bonds, domestic bonds, international bonds, and the list goes on. What’s more there are nine (9) different types of credit ratings for each type with corresponding changes in yields—there are even non-rated bonds!

If you remember one thing from this week, please remember this—not all bonds are the same and as a consequence should not be viewed the same when making investment decisions.

How The Different Types of Bonds Have Historically Acted During Rising Rates

People hear interest rates are, or should begin, going up and they immediately assume they need to sell all their bonds. As we discussed above, that largely depends on what types of bonds you hold.

In general, rising rates will cause greater and more “permanent” losses for Treasury bonds and other high-quality bonds whose value is almost entirely a function of interest rates.

However, for other types of bonds their value is not just a function of their yield relative to current interest rates, but also their credit worthiness and the likelihood of their potential default. Usually interest rates rise during times of economic strength, which in turn decreases the likelihood of default among lower credit quality bonds.

The chart below looks at all the periods of rising rates over the last 20 years, and the total returns for various types of bonds during those periods. As you can see from the chart, the lowering of their default risk along with their continued income stream usually more than offsets any potential losses from an increase in interest rates. This has historically resulted in a positive total return for most types of bonds outside of Treasuries and high-quality corporate bonds, despite short-term fluctuation in their values.

Another Way Rising Rates Can Actually Help Bond Investors

Rising rates can also help fixed income investors in another way—namely the ability to reinvest the income they receive into higher yielding bonds.

Look at the chart below. It demonstrates two key concepts. The first is simply that the type of volatility and short-term losses even high-quality bonds (the bonds most at risk) would experience during periods of rapidly rising interest rates pale in comparison to the losses investors have gone through in real estate and stocks at various times in history.

Secondly, and more importantly for this discussion, is the unique ability of bonds to pay an income stream and have that income reinvest into bonds with higher yields as a result of rates rising. This actually results in a greater overall return than if rates had never changed, all the while providing diversification for investors holding other types of risk assets.

Summary

As a kid I loved to go swim in the lake when the waves kicked up. I also remember feeling like the bigger waves were always “over-there” and trying to swim back and forth to the “better area.” Eventually, I realized all I was getting for my efforts to catch the next big wave was actually missing out on riding the waves (and a little tired).

We all face the same temptations as investors to change our locale (allocation) to catch the bigger wave that always seems to be somewhere else, and yet history shows us just like wave chasing, performance chasing usually gets one nowhere. Rather it is patience that brings the most rewards.

There are also times when the waves aren’t fun at all, and we fear they may take us under. The volatility of this year, and odd market moves of the last month, have tested many investors nerves—most recently concerning the bond markets. Keep in mind that such volatility is what creates great opportunities for those that can keep their focus.

That type of constructive perspective is what we hope to provide for our clients, coupled with in-depth due diligence and know-how to navigate volatility to a successful result.

I hope the information above helps you better understand the multiple facets/types of bond markets and to avoid the pitfalls of reacting to overgeneralizations in order to become a better investor.

Have a great weekend,

Tim and the team at TEN Capital

Forward

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