A quick word about recent market volatility.

In February, investors experienced a level of volatility that’s been absent from the market for the last few years. But while shifts in the market can be alarming, it’s important to understand that, historically, this level of volatility is not unusual. That’s because the stock market has actually averaged about a 10 percent correction each year throughout its history. Market volatility is but one key reason that we encourage people who own stocks to be invested for the long term. Simply, you wouldn’t want to retire with all your money in equities, only to see the market experience a major drop in value. If you have a question about the markets, or your investments, or you want to make certain that your plan is on track to help you retire well, contact Hanson McClain today.

Inflation and Rates

With the recent market volatility, it’s helpful to take a step back to try and better understand the possible causes. Yes, it’s true, there were some heavily invested in short volatility strategies, and these trades have largely been unwound, but there was also some concern about higher inflation and higher future rates. Today, we will discuss how various investments perform with higher inflation and higher rates. Before we look at this, let’s spend a few minutes reviewing the current conditions of the economy and the markets to have the right context. They are a) monetary and fiscal policy; b) a prolonged period of very low borrowing costs; c) expensive valuations on both stocks and bonds.

Monetary and Fiscal Policy

While the Federal Reserve is removing support by raising rates and no longer purchasing longer-maturity securities, Congress just passed a massive tax cut and effectively lowered tax rates for many corporations and individuals. Usually, such fiscal stimulus comes when the economy is sputtering, not when it is running hot. Higher economic output and very low unemployment, along with tax-related stimulus, could put more pressure on prices and cause personal expenditures to rise via higher inflation. Exhibit A shows the balance sheet of the Federal Reserve compared to the S&P 500. The S&P 500 has had plenty of monetary expansion as the backdrop to keep rates lower for longer, and this support is now being gradually removed. We have never had a balance sheet this large and unwinding, so it too may put some upward pressure on rates. We have also not seen a corporate tax cut like this before.

Exhibit A:  Federal Reserve Balance Sheet vs. S&P 500

Low Borrowing Costs

Having access to low interest debt can greatly improve a company’s balance sheet. It can also allow companies to borrow more and leverage more, both of which can have harmful consequences. For consumers, while very low rates can make it more affordable to buy a home, they can also put too much upward pressure on prices. Low costs to borrow are not good for lenders, nor are they good for people who invest in bonds. Many people may recall the days of earning six percent for a one-year CD. After nearly four decades of interest rates declining (as measured by the 10 year US treasury yield), it appears that rates may now be breaking out from the long secular downtrend and moving higher. Exhibit B shows the long-term downtrend in rates and where rates are now. The red line is where rates bottomed out, the amber line is the 200-day moving average, and the white horizontal line is the three percent level. Rates have moved out of the green trend channel, and the 200-day moving average is also close to moving out of the trend channel. Exhibit C shows rates for the 10-year (yellow line) and 30-year (white line) Treasuries both climbing higher.

Exhibit B:  Long-term Downtrend in Rates
Exhibit C:  10-Year and 30 Year Treasury Rates

Expensive Assets

With the exception of commodities (and perhaps a few other asset classes), everything is expensive. Stocks are expensive. Investment grade bonds are expensive. High yield bonds are expensive. Real estate is getting expensive. It is not a question of whether or not something is expensive, but rather, how much more expensive is one investment relative to another? As long as inflation is low and the cost of capital is low, assets can be priced higher than they otherwise would be. If inflation moves higher, the most expensive (and those most sensitive to higher rates) will most likely be adversely affected.

Bonds and Higher Inflation and Rates

While most bonds have no hedge against inflation, Treasury Inflation-Protected Securities (TIPS), and those investments that are not tied to a fixed rate, such as bank loans or floating rate notes, can help offset rises in inflation. Assuming rates increase to head off expected, but not realized, inflation, bonds and other asset classes that have a high sensitivity (long maturity/duration, lots of leverage) to interest rates will do poorly, especially if rates spike higher instead of gradually moving higher. While the yield curve for treasuries flattens, it may appear more attractive to stay in longer maturities as these haven’t moved as much as the short end of the curve. The problem is the degree of sensitivity to rates. A short-term bond with a duration of 1 will decline approximately one percent with a one percent increase in its rate. A long bond with a duration of 10 will decline approximately 10 percent with a 1 percent increase in its rate. So, even though rates have moved a lot more (and will likely continue to move) for short-term bonds, the pain for these large moves is smaller than a ¼ point move for much longer maturities.

Exhibit D is today’s active treasury yield curve compared to 1, 3, and 5 years ago. Within the context of today’s environment, high-quality long maturity bonds are not only risky from a duration standpoint, these are also expensive. Currently, it’s not uncommon to find bonds priced well above par value. What does this mean? It means that if a 5-year bond is priced today at $105, one will only get $100 in 5 years when it matures. If the yield of the bond cannot compensate for the loss of $5 to the principal, you may lose money when it matures. And since the Federal Reserve is not actively buying any more of these high-quality bonds, the demand must come from somewhere else.

Exhibit D:  U.S. Treasury Actives Curve

A lack of demand can push rates higher if there are more sellers than buyers. The silver lining in higher rates, of course, is that one need not invest in risky or long duration bonds for income once rates have significantly moved higher. This also means that the riskier parts of the fixed income market would pay much more in income than they do now.

Stocks and Higher Inflation and Rates

Stocks generally do well when rates are moving higher due to a good economy. Stocks, unlike most bonds, can be considered a hedge against inflation. If there is slack in the economy, and rates are gradually rising, stocks can continue to rise as part of the recovery. If there is no slack in the economy and rates rise, higher rates can start eating into profit margins and can be a tax on earnings. If there is stagflation (stagnate growth and high inflation), stocks can perform very poorly while rates are moving higher. Since stocks are already considered expensive, a whiff of higher inflation may mean that price multiples, such as Price/Earnings, may move lower. With the current environment, higher rates may reduce earnings while some small increases in inflation may weigh some on prices, given the current valuations. But it is also quite possible for stocks to move higher and higher and get more stretched in valuations so long as rates and/or inflation don’t pick up abruptly. With the tax cuts currently working their way into the system, it’s likely that earnings will continue to grow, possibly helping valuations to come down without bringing down prices, but at a decelerating rate if rates keep moving steadily higher.

Mind the Gap

After being in “recovery” for several years, the actual GDP output has fully caught up with the potential GDP output. This is termed the output gap. When the output gap is closed, the economy may start to overheat or run hotter than normal. This can also happen when inflation starts seeping into the economy. Not to sound too ominous, but the last few times that the output gap was closed we experienced a recession. The good news is that, in regard to the last few recessions, a recession didn’t occur for 2-5 years until after the output gap had closed. Exhibit E shows this in better detail. The red shaded areas mark recessions and the red line marks the output gap being closed.

Exhibit E:  Output Gap

Summary

We continue to vigilantly watch the economic environment. If inflation fears abate and normalize and rates continue higher per the Fed’s guidance, we may see stocks continue to do well and bonds to struggle some. Stocks are not likely, however, to repeat the same performance as last year and we continue to believe that having exposure to international stocks, which are priced more attractively than US stocks, will help portfolio returns. We are also watching the yield curve spreads between 2-year and 10-year bonds and more signs of inflation. The Federal Reserve has the challenge of normalizing rates with very low unemployment and now a closed output gap, but also has the challenge of not raising rates so quickly as to push the economy into a recession. We are reminded always at this stage of the business cycle of Goldilocks, having it not too hot and not too cold, but just right.

Source: Charts and data referenced here come from Bloomberg.
The S&P 500 Index is a broad based unmanaged index that consists of the common stocks of 500 large capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange.
Past performance does not guarantee future results. Any stock market transaction can result in either profit or loss. Additionally, the commentary should also be viewed in the context of the broad market and general economic conditions prevailing during the periods covered by the provided information. Market and economic conditions could change in the future, producing materially different returns. Investment strategies may be subject to various types of risk of loss including, but not limited to, market risk, credit risk, interest rate risk, inflation risk, currency risk and political risk.
This commentary has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security or instrument or to participate in any particular trading strategy or an offer of investment advisory services. Investment advisory and management services are offered only pursuant to a written Investment Advisory Agreement, which investors are urged to read and consider carefully in determining whether such agreement is suitable for their individual needs and circumstances.
Hanson McClain Advisors and its affiliates and its employees may have positions in and may effect transactions in securities and instruments mentioned in these profiles and reports. Some of the investments discussed or recommended may be unsuitable for certain investors depending on their specific investment objectives and financial position.
Hanson McClain Advisors is an SEC-registered investment advisor that provides advisory services for discretionary individually managed accounts. To request a copy of Hanson McClain Advisors’ current Form ADV Part 2, please call our Compliance department at 916-482-2196 or via email at compliance@hansonmcclain.com.
February 20, 2018
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