After tirelessly lifting weights for three plus years we have attained the desired results. As such, it is time put down the barbell and move investment grade fixed income portfolios closer to neutral duration. While the average body type of a Performa employee can hardly be described as chiseled, our investment grade fixed income portfolios have been doing some heavy lifting. The short duration and barbell strategy employed for the last few years has been a positive for index relative performance as easy monetary policy abated and interest rates rose from historical lows.
For the last three years, Performa’s investment grade fixed income portfolios have been positioned in anticipation of higher interest rates and a flattening yield curve (i.e., the gap between short and longer term yields decreases). This positioning has consisted of being short duration vs. the index combined with a barbell – owning floating rate bonds on the short end of the yield curve and longer fixed rate instruments on the other. Our investment thesis was twofold, we would maintain our short duration, barbell stance until 1) interest rates reached our equilibrium target of approximately 3%, and 2) selling our floating rate holdings for fixed rate securities achieved the right risk/return profile.
Throughout the current rate hiking cycle we have continually examined the relationship between floating rate yields and U.S. Treasuries, checking to see if the above two conditions had been satisfied.
For example, in early April it would have cost portfolios roughly 8 basis points of yield to remove the barbell (sell the floaters) and buy 2 to 3-year U.S. Treasuries. Back then, both 3-month LIBOR and 2-year U.S. Treasuries were around 2.25%. Although there was no difference between the two in yield, the market was not at or near our 3% target therefore positioning was left unchanged.
Fast forward to today and prevailing market conditions are significantly different. The spike in LIBOR rates that occurred between last fall and the spring has flat lined, and the Federal Funds rate now sits at 2.25%. Meanwhile, the yield on 2-year U.S. Treasuries all the way out to 30-year U.S. Treasuries have compressed around 3%. Therefore, we now feel it is time to unwind the barbell by selling floating rate corporate bonds, and buying longer, fixed rate assets.
Our objective is to achieve the following results:
While the nature of this unwind will naturally extend the overall portfolio duration, we are not taking portfolios all the way back to neutral. We feel the business cycle does have further to run and there is a back drop of the ballooning U.S. deficit with implications for Treasury issuance down the road. Lastly, markets tend to overshoot in both directions. While our equilibrium target of 3% is at hand, it is possible that interest rates spike briefly as positions unwind – that would typically be a good time to bring investment grade bond portfolios back to neutral.
As always, we will keep you apprised of any significant changes in our investment thesis, but please do not hesitate to contact us with any questions in the meantime.
We think the above hip-hop lyric succinctly sums up the first quarter of 2018. The market’s ode to the genre is timely as Kendrick Lamar just wrapped up the first Pulitzer Prize in music ever won by a hip-hop artist. The first quarter of 2018 was a battle. With the hype of tax cuts, stashed offshore dollars coming home and all other things Trumpian, equity market participants chose their sides, suited up, and entered the ring.
Early January was a bull market continuation until the Bears started throwing haymakers. With U.S. led global monetary tightening trends and mounting political and geo-political risk in their corner, the Bears took charge and pummeled the market with large flurries of volatility. Bulls played defense and counterpunched with soon-to-be announced solid Q1 earnings potentials and bags of money that should line shareholder pockets over the coming 12 months.
Who won? Let’s call it a stalemate for now as the S&P 500 return was only slightly negative for the quarter.
However, we believe that gravity has taken hold. Q1 will likely represent the cycle top for equity markets, with the S&P 500 rising to just below 2900 index points. It would take a Herculean effort to pierce this ceiling during the remainder of the year and any attempt to breach those January highs that falls short is certainly a double top indicator and a selling opportunity.
The first quarter might not have been the epic Ali vs Frasier type of bout, but certainly a more pedestrian Holyfield vs Tyson fight seems like a reasonable comparison.
For the past few years, the equity market mantra has been “buy the dips”. The theory has been that economic fundamentals, easy money and new fiscal stimulus provide significant tailwinds for equity valuations in the absence of being able to find returns in other asset classes. Previous downturns were quickly met with large buying programs and stock buybacks, working to reverse losses within weeks. Additionally, price volatility fell to historically low levels.
That dynamic changed in the first quarter. As Bulls and Bears exchanged body blows, the path forward for equity markets became less certain. The underlying belief in higher prices waned and for the first time since early 2016, we saw two-way risk being priced in the marketplace as volatility violently spiked higher.
While consensus has not fully moved to “sell the bounce mode” yet (likely waiting for another attempt to sell closer to the January peak), “buy the dip” has become a more onerous proposition. This simple, yet subtle shift in sentiment has significant market implications and is one of the factors behind our belief that equities have seen a top.
In our opinion, the return of two-way risk in equity markets has been long overdue and is certainly a welcome and healthy development. Suppressed volatility over intermediate periods of time shows complacency, which is both unhealthy and sets the table for future shocks. It also contradicts the need for inflated valuations, driven by years of experimental quantitative easing, to reverse course as the tide of easy money goes out with shifting central bank policies.
Moreover, these evolving equity market dynamics have left interest rates caught in the crossfire. Bond markets are dealing with their own conundrum of positive and negative influences. On the positive side of the equation is shrinking corporate supply due to offshore profit repatriation and the potential for corporate balance sheet improvement. Additionally, the massive yield differentials versus other sovereign debt remains a positive for U.S. rates. On the negative side is ever increasing U.S. Treasury supply in the face of reduced Fed purchases and tax cuts that will balloon the deficit fairly soon. Oh yes, the Fed is hiking interest rates and commodities have been grinding higher too!
Interestingly, while rates are higher over the past nine months and bond prices have fallen, there is a point at which enough equity market selling causes the bond market to retake its safe-haven status from time to time.
Investors will retreat to their corners during the first half of the second quarter with eyes glued to corporate earnings and economic data, like in the good old days. However, it would not be surprising to see the boxing ring lights fire up again mid-quarter or earlier. If earnings do not meet expectations and the beneficiaries of repatriated cash ends up in the hands of bondholders through corporate balance sheet cleanup and not with shareholders via more dividends and new buy back announcements, then the Bears will come out swinging again.
In any event, the challenge for all investors is to stay focused and not get distracted by the daily presidential tweet storms and look out to the horizon. Maybe the #deletefacebook movement could morph into #deletetwitter and the noise would fall ever so slightly.
Looking at the next nine months, there are still a few reasons to be optimistic. The current economic expansion will not end this year as key economic indicators remain constructive, favoring the muddling-along characteristics that have defined this elongated cycle. Some early indications from Q1 earnings have been positive. And perhaps Q2 earnings will be even more telling since earnings are backwards looking. Additionally, looming mid-term elections may be supportive. Grid lock has to be better than what we have seen over the past year. 2019, however, is looking more ominous. Be wary of following the dip buying mentality and carry a heavy dose of skepticism.
* “Lose Yourself” (Eminem, 2002)
In our 2018 outlook, we discussed the complacency within financial markets and the lack of volatility in almost every asset class. As a result, we thought that prices could be susceptible to an abrupt reversal without notice. Well, early February was a wake-up call. The February selloff was sudden and sharp with the S&P 500 giving up over 12% at the lows. Intraday trading ranges, which had been less than 1% for a considerable amount of time, suddenly blew out to 3% – 4%. Some investors booked profits while the hoard of new equity dollars from January pulled out and those sellers licked their wounds. Quant funds and momentum players applied additional pressure by putting on fresh shorts when the markets quickly sold through stop losses. The biggest damage, however, was reserved for strategies that were short market volatility.
The sudden and sharp spike in volatility caused a mini unwind of the trade that has worked so well during an era of Central Bank asset purchases and zero interest rates. Namely: buy stocks, buy bonds, short market volatility, and forget about it.
During the volatility-drenched trading days of early February, the pundits conducted a feverish search for the catalyst. Who or what was to blame for the startling shift in market sentiment? Maybe 10 year U.S. Treasury yields trending toward 3% with rising wage inflation sparked the market rout? Perhaps greedy Wall Street firms creating problem child Exchange Traded Notes & ETFs were to blame? Somehow, individually these explanations seemed to miss the point. More likely, the sense that everyone is walking on eggshells meant that when the first sign of smoke appeared, everyone raced for the same exit door. Sell first and ask questions later, is a pretty standard response to these types of moves. Interestingly to us, there are some differences in market structure today versus the past.
The rise of technology used to run trading programs has advanced significantly over the past decade. Instead of humans trading everything, now humans program algorithms that execute trades autonomously. Many programs are built with momentum indicators which tend to exaggerate moves in either direction if stop loss triggers are hit. Quick and aggressive down trades now come with equally sharp reversals – like the early part of this month. There have been a number of these moves over the past five years. People used to call them flash crashes, but let’s assume for now it is more normal. If one looks at trading patterns around the Brexit referendum and U.S. Presidential election, they are similar to what we have seen over the past few weeks.
So instead of looking for the catalyst like a needle in the haystack it is just better to remember that in many cases, price action is the real story.
Even though the equity markets rebounded swiftly last week, the move should not be swept under the rug and forgotten. Instead, place it in a broader context. From a fundamental perspective, not much has truly changed. The probability of a near term recession remains fairly low. The Federal Reserve is in tightening mode while inflation is trending higher. Additionally, the markets have been looking for fiscal stimulus from Trump for over a year and finally got a taste of it via tax cuts. But that was two months ago and the associated deficits will increase government bond issuance.
In a world of artificially low interest rates, the decade long search for return has been aggressive and unwavering. These dynamics not only incented weaker hands (who tend to sell at inopportune times) to dip their toes into unchartered territory, but also encouraged the development and adoption of new products and trading strategies. The rise of black box and high frequency trading strategies, coupled with Central Bank inflated appetite for return, has made markets more prone to the type of moves we witnessed in early February.
As this business cycle wears on, we are focused on two things. First is dry powder and liquidity. That is making sure we have the ability to add exposure when volatility creates opportunities. Second is our investment time horizon. When faced with seemingly random and violent market fluctuations, the only way to avoid getting whipsawed is to take a step back and view the short term volatility in broader context of long-term investment objectives. That’s why now more than ever being able to see through near-term volatility and identifying long-run value is paramount.
Lastly, this spike in volatility should not be met with fear and insecurity. Instead, it should be greeted with bright eyes and excitement. It is exactly these types of market environments that provide the opportunity for active managers to add value for their clients. That leaves us in a much better environment than practically all of 2017.