As the last quarter of 2017 begins, market sentiment continues to be overwhelmingly positive. The calm in the markets we wrote about last quarter has proven to be resilient. It seems nothing will scare off the unicorns grazing on the front lawn of the New York Stock Exchange. Geo-political tensions may rise (North Korea) and the Federal Reserve may tighten monetary policy (increasing interest rates and reducing the assets on their balance sheet), but the market continues its climb.
The calm is not without some good reason. A sober look at the details of these notable events reveals very little immediate risk to the economy or businesses. I by no means profess to be a geo-political expert, but conflict in Asia looks unlikely in the near term. Kim Jong Un seems far too interested in staying in power to make the one decision (starting a war) that would with certainly result in him being removed. Despite President Trump’s aggressive public stance, the US is unlikely to start another war in Asia unless it is absolutely necessary. In addition, China has stated that it will not support North Korea if they fire first but will protect North Korea if the US or its allies takes the first action. It looks like things will need will need more time to percolate before open war starts, if it starts at all.
As to the monetary tightening, the members of the Federal Reserve Board (FRB) act as if they have taken the Hippocratic Oath: “First, do no harm.” The board members have no interest in upsetting the current economic recovery. From 2008 to 2013, the FRB took unprecedented steps to stabilize and stimulate the economy by providing banks and other financial institutions with liquidity through the purchase of treasury securities, mortgage backed loans and other debt instruments. As the chart to right shows, the FRB increased the Federal Reserve Assets from $600 billion in 2008 to around $4.5 trillion in 2013. That’s an increase of 7.5 times. This wholesale purchasing of assets allowed banks to bolster their balance sheets (most of the money went back to the Federal Reserve. See chart on the following page…how convenient) and suppressed interest rates so companies – and households – could restructure their debt at lower rates.
Since 2014, the FRB has cautiously withdrawn this stimulus and has now started the process of unwinding it through interest rate increases and outlining a plan to reduce the assets on its balance sheet. Removing this kind of stimulus from the economy is no small deal. The FRB has been committed to cautiously making adjustments when they see that the strength of the economy warrants it. They telegraph every move far in advance to give financial markets time to digest their decisions and adjust. Markets have acclimated and become comfortable with this process.
There were also positive developments during this last quarter that appear to have further bolstered market sentiment. Q2 GDP growth was recently revised up to 3.1% annual rate. This is the first time a 3% growth rate has been achieved since 2015. In addition, Congress and the White House have re-centered their focus on tax reform. While the details have yet to be worked out, the various proposals are favorable to economic growth, at least in the short term. Certain measures – such as the one-time preferred corporate tax rate on repatriated money and the reduction of the corporate tax rate – have the potential to push more cash into the economy, which could stimulate corporate profits and economic growth.
All-in-all, the external backdrop looks favorable for the market. But risks are still plentiful. North Korea is a reminder of the geo-political tensions that exist around the world, and although the near-term probability of conflict in that region seems low, things can quickly change. The Federal Reserve Board can use caution and telegraph their every move, but they are again embarking on an unprecedented operation with unknown consequences. And we have all seen how well Congress and the White House work together in passing a bill. Tax reform is in the bag! Right? While the immediate backdrop looks calm, we remain mindful of where we’re at: as we have discussed at length in past writings, US markets continue to be at rich valuations, markets are complacent, stability tends to create instability – as the economist Hyman Minsky hypothesized – and we have experienced one of the longest and weakest economic expansions in US history. All seems calm now but that could change fast.
Investment Commentary – Return Free Risk
The struggle in a market like this is continuing to find assets that are priced well. The Federal Reserve’s maneuvering has caused inconsistent price manipulations that have distorted markets and left investors with little option other than to price securities almost solely based on the decisions of the Federal Reserve. This is clearly the case in bond markets.
In typical market conditions, a bond holder will receive more interest for bonds that mature at later dates. If you have ever purchased a CD at a bank, you have experienced this: a 1-year CD pays more interest than a 6-month CD; a 2-year CD pays more interest than a 1-year CD, etc. Typically, it works the same in the US treasury market: a 5-year bond will pay a higher interest than a 2-year bond; a 10-year bond will pay more than a 5-year bond, etc. When you plot these interest rates on a chart, you get what’s called a yield curve.
The chart to the below shows the yield curve as of two dates: The current October 2017 (blue line) and the beginning of year January 2017 (orange line). What has happened over the last year is that the yield curve has “flattened”. The interest rate on longer dated bonds – like the 30-year bond – have gone down (the end of the blue line is below the orange line), while the shorter dated bonds – like 1-year – have gone up (the beginning of the blue line is above the orange line). This is not an abnormal phenomenon. If fact, it is a normal occurrence in the credit cycle and is typically indicative of deteriorating economic conditions.
However, other portions of the bond market are behaving in ways indicative of economic growth. Just as investors receive more interest for loaning their money out for longer periods of time, they also receive more interest for loaning money to less “credit-worthy” borrowers. Companies with poor balance sheets and negative cash flow will have to pay more interest on their loan than Apple, who has $100 billion+ in the bank. The difference in the rate these two borrowers pay is called the “spread” (I know…a lot of finance terms. There’s a quiz at the end). For example, if Apple is paying 2% and Sprint is paying 6%, then the “spread” is 4%.
The chart below graphs the average spread for the last year of junk rated bonds over US Treasuries. During this time, the spread has narrowed…the difference between what “safe” bonds are paying and what “risky” bonds are paying has decreased. This is also not an abnormal occurrence but is indicative of improving economic conditions.
Under “traditional” interpretations, these markets are giving us conflicting reports. The Treasury Curve is telling us things are getting worse, and the High Yield Spread is telling us things are getting better. Why? I have my speculations on what the tea leaves are trying to tell me, but right now I’m more concerned with how they are making my water taste: with the curve flattening and spreads narrowing, investors are being paid less for increased risk. That’s not very good tea.
A good example of this is our recent experience in Senior Secured Floating Rate Bank Notes. In August of 2013, we committed a sizeable percentage (5-10%) of portfolio assets to these securities. They offered good value relative to the rest of the bond market, the contracts were written with a lot of covenants (covenants are requirements lenders force upon borrowers to manage their risk), they offered interest rate protection, and default rates were low. This past quarter we unwound the positions. When we purchased these securities, we were earning over 5% interest. That number is now around 3.75%. While that’s been good for us on a total return basis (when bond yields go down, prices go up), it is not much to be paid on loans given out to low credit quality companies. In contrast, we could buy highly secure companies for 2.2% interest. If default rates on the Bank Notes were to inch up to historical norms, then we would be receiving almost no additional compensation for the increased risk we were taking. In addition, loans were being issued with fewer and fewer covenants, which further reduced our protection. To steal a phrase from another portfolio manager, we were getting return free risk. Given the changes, we sold the positions this last quarter. The risk was no longer worth the reward. We will continue to look for opportunities to invest capital at an acceptable level of risk.
Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.