To Our Valued Clients,
January 2018 felt much like a continuation of 2017, however, the market environment in February and March could not have been more different. We were reminded that market volatility exists, as we moved out of one of the lowest volatility years on record into a new wave of normalized volatility in financial markets. Despite the reintroduction of volatility in the marketplace, the continuation of above-trend global growth leads us to remain constructive on risk assets in 2018, as earnings growth continues at a double-digit pace combined with fiscal policy catalysts.
In March, the Federal Reserve (the Fed) raised the Federal Funds Rate and signaled two more rate hikes in 2018. Now, investors may be wondering how further rate increases might affect the fixed income portion of their portfolios. As we know, bond prices and yields have an inverse relationship. All else equal, when interest rates rise, bond prices decline and vice versa. Yet, investors should look beyond the short term movements of bond prices and interest rates and consider the longer-term importance of holding fixed income within a portfolio.
2018 could be the turning point when the “bond bears” finally wake from their 30-year slumber, as we see Treasury bond yields rising in a meaningful way. Economic growth continues to accelerate domestically and globally while fiscal policy is becoming more extensive. More importantly, the era of unprecedented easy monetary policy is coming to an end, as the Federal Reserve continues to tighten through rate hikes and balance sheet normalization. The European Central Bank (the ECB) is set to slowly reduce its quantitative easing program and even the Bank of Japan (the BOJ) is seeing progress in creating a positive, normalized inflationary environment due to expansive monetary policy measures. As the easy-money era comes to an end over the intermediate term, it is becoming increasingly important to remain agile and flexible in the fixed income space.
As the Fed has increased short term interest rates over the past few years, the Treasury yield curve has experienced dramatic change. Short term yields have risen sharply from near-zero levels while long term rates have fallen. The yield curve has been one of the more reliable leading indicators of economic growth and inflation for many cycles over the years. A flattening yield curve has commonly been a signal of slower economic growth ahead, while an inverted yield curve (when short term rates are higher than long term rates) has preceded every recession since World War II. However, the curve’s predictive value is not absolute and
occasionally sends misleading signals, like the case of the 2013 steepening of the curve. We believe the recent flattening of the yield curve is once again giving us a false positive as it relates to the potential for slower growth in the near future. Instead, growth continues to expand globally due to a number of fundamental factors combined with massive tax reform and fiscal expansion in the US.
Although traditional core bond strategies play an important role in portfolios as an equity diversifier, today’s environment may warrant a fresh look at this approach. The Bloomberg Barclays US Aggregate Bond Index was down roughly 1% from January 26-February 8, 2018, while the S&P 500 was down nearly 10% during the same timeframe. Historical correlations suggest that core bonds should deliver positive returns when equities falter, but due to an increase in inflation expectations, this led to fears that the Fed may have to tighten faster than anticipated. Clearly, this is much too short of an observation period to consider a trend, but it is something that we have been watching.
How do we attempt to reduce the level of interest rate sensitivity in the fixed income portion of a portfolio? By adding an allocation to short term bonds to complement core bond positions, we attempt to reduce volatility while maintaining an attractive yield. Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates. A bond or bond portfolio with a lower duration will typically be less sensitive to movements in interest rates than a bond with a higher duration, all else equal. For example, a bond portfolio with a duration of 5 years will have its price drop by approximately 5% for every 1% increase in interest rates. By adding low duration bonds to a portfolio, the portfolio should theoretically experience smaller price movements in the face of rising rates versus its longer duration counterparts.
It isn’t whether rates rise that matters, but whether they rise by more than the market expects. The underlying rationale for holding fixed income securities within a portfolio does not change with that of Fed policy or yield curve shape. Bonds are generally viewed as defensive instruments due to their lower volatility than risk assets. Although bonds do experience fluctuations in value over time, they historically do not move nearly as much as equities, for example, and play an important role in a portfolio as a volatility dampener and diversifier. Active management can also provide added value in changing environments, as managers can proactively manage exposures to certain fixed income sectors during a rate hike cycle. For the long-term investor, we must remember that prudent research and analysis is key in any market cycle and, historically speaking, bonds are the asset class that puts the “balance” in a balanced portfolio.
As we head into the second quarter of 2018, we wish you and your families a happy and prosperous spring season. We thank you for your ongoing trust and confidence, and hope we can continue to help you discover The Next Piece – to Your Peace of Mind ™
Josh Williford, MSF
Director, Empowered Investor
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