The most visible event of the 2nd Quarter was the United Kingdom’s decision to leave the European Union. The global stock market reacted sharply both negatively and positively, the end result being a modest gain for the 2nd Quarter. Politically, the UK’s departure from the EU is without precedent. No significant country has left the EU since its formation. As such, “Brexit” remains top of mind for many clients. The process of the UK’s exit will take years, and the political and economic implications cannot be accurately predicted. Given our expectation of continued high volatility in European markets, we will continue to underweight foreign stocks and overweight U.S. stocks in the portfolios.
While not as visible as “Brexit”, the most notable event in the markets this year is the strong performance of bonds. U.S core bonds returned over 5% during the first 6 months of 2016 (see table above), easily beating the returns of both global and U.S. stocks. During the same 6 months, the rate on the U.S. 10 year Treasury fell from 2.27% to 1.49%, a decline of over 30%.
The leading factor in the surprising performance of bonds is basic negative investor sentiment towards risk-based assets. This “risk-off” attitude has resulted in an investor bias towards the perceived safety of bonds. Data from mutual funds bears this out. Despite historically low interest rates, fund flows YTD have heavily favored bond funds at the expense of stock funds. This demand has resulted in higher bond prices and, in turn, lower yields.
As bond prices move opposite to yields, bond prices have also been helped by interest rate cuts by many global central banks, including negative interest rate policies enacted in Japan and parts of Europe. Negative rate policies represent an extreme version of monetary stimulus that in theory is meant to encourage borrowing. In reality, however, negative rates have had the opposite effect, undermining investor confidence and leading to even greater risk aversion. Negative rates can also squeeze bank profits, incenting banks to either raise lending rates or lower lending standards, both unintended consequences. The negative rate concept remains difficult to comprehend and is something we believe to be economically unsustainable over longer periods of time.
Finally, with approximately 74% of global government bonds yielding less than 1%, including almost 36% with rates below zero, many foreign investors have been drawn to the U.S. Treasury market. Consider a 10 year U.S. Treasury bond yielding 1.46% as of this writing, compared to a 10 year German bond with a yield at -0.13%, and it’s easy to understand the relative appeal of the U.S. market. Foreign buying of U.S. Treasuries has put further downward pressure on U.S. rates, a trend that is not expected to significantly abate in the near term.
Historically low bond yields can reflect low expectations for both growth and inflation. So is the bond market signaling a recession? The U.S. economy is expected to grow by about 2% this year, while core inflation has been trending higher at 1.6%. Jobs data has been strong, with the official unemployment rate falling below 5%. Jobs strength, in turn, has led to strength in consumer confidence and consumer spending (2/3rds of GDP), and is starting to result in greater wage growth. The housing market has shown strength over the past several months, helped by solid employment and low interest rates. Finally, manufacturing, which has been hurt over the past year by a strong dollar and the weak energy market, has recently improved. While risks remain, these data points in aggregate suggest that the U.S. economy is not at a recession tipping point, but instead relatively stable. As one economist recently put it, he would not characterize the U.S. economy as a “sick hare”, but rather as a “healthy tortoise.”
Although we think it’s likely that interest rates stay lower for longer, we view current U.S. economic data as inconsistent with 10 year Treasury rates below 1.5%. While there are often dislocations in the short term, stable economic fundamentals should eventually create upward pressure on interest rates. We believe interest rates have the potential to gradually move higher over the next 6-12 months, more accurately reflecting the underlying factors noted above.
Even with a gradual move up in interest rates, we expect U.S. core bonds to earn 2.5-3% going forward, much lower than the historical average. Accordingly, we are maintaining a relative underweight to traditional bonds across most portfolios, preferring to shift some of that allocation to hedged investments such as structured notes, long/short equity, and market neutral funds. Going forward, we believe these strategies have the potential for greater returns than bonds, with less volatility than stocks. Our stocks remain heavily weighted to the U.S. market, with an emphasis on systematic funds that are both high quality and low cost. With interest rates extremely low, a second half pick-up in corporate earnings could provide the necessary catalyst for stocks to break out of the current trading range, volatility notwithstanding.
* Information provided should not be construed as investment advice and is not meant to be taken as a recommendation to buy or sell. The financial situation and investment objectives of each individual must be considered for suitability prior to any recommendations being made.