Market Perspective

What Did He Just Say?

Last week there was a change in U.S. monetary policy. Gone is the regular drumbeat of ¼% short term rate increases that we have seen since December 2016. The straight-talking and pragmatic Federal Reserve Chairman, Jerome Powell, announced a dramatic about-face after the January 30th FOMC meeting. This striking shift towards a dovish policy tone surprised the markets. We believe that it warrants careful consideration as monetary policy is a key macro input when evaluating intermediate and long-term positioning for all asset classes.

Let’s Get a Few Things Squared Away With Respect to Monetary Policy

First, the conspiracy theorists have been loud and particularly ill-informed when harping on the Fed and its duties. Neither Chairman Powell nor the other FOMC members are influenced by political pressure or any public chastising that may come from this, or any other, White House administration. The Fed always focuses on its dual mandate from Congress (manage inflation and achieve full employment). An independent Central Bank is at the core of the U.S. economy and its governmental structure. Sometimes those policies will align with perceived political pressures (January 2019 meeting) and other times they won’t (December 2018 meeting).

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Second, the Fed needs to gather as much ammunition as quickly as possible to fight the next economic downturn. Rate hikes continuing toward a 3% Fed Funds Rate will achieve the goal and, in our view, should continue until economic data no longer provides the cover. While the markets are not fond of continual increases (they never are!), they will be happier in the long run. If the Fed fails to gather enough ammunition, the unconventional, “extraordinary” monetary policy measures used after 2008 will become normal. It is not practical to address each recession with a bazooka of quantitative easing (QE). The longer-term effect of using more QE to fight normal policy battles is akin to a vaccine wearing off and leaves the U.S. economy to turn down the same road as Europe and Japan.

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Third, the Fed’s greatest fear is stagflation or deflation. While these carry a low probability today, the expected long-term costs of stagflation would be high. Rising inflation and slowing growth would be the worst-case scenario for financial markets and the Fed understands this risk. If markets perceive that the Fed has lost control of its inflation fighting powers, the volatility experienced this past December would feel tame. As such, it is incumbent on the Fed to maintain its prior hawkish streak to keep hold of its credibility on the inflation front. The best way to do this is to continue with gradual interest rate hikes.

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As we enter 2019, there are several stories worth watching. Whether it comes from a Brexit resolution or an end to the U.S./China trade war, a reduction in uncertainty should provide solace to the markets. Investors will still have to deal with the Federal Reserve raising rates in 2019. While the Fed has lowered its signal to two rate hikes this coming year, those calling for one or zero may be missing the point. The Fed, with sufficient cover, must continue to raise rates to gain as much ammunition for the next recession as possible. Speaking of recessions, we continue to believe the current expansion will become the longest on record; however, we have continually targeted 2020 as a potential tipping point and our view has not changed.

So How Do Those Three Points Jive with Last Week’s Messaging? They Don’t.

The dovish pivot, while aggressive and unsettling, was not a concession to President Trump. Instead, the Fed felt that the outlook for global growth is cloudier today than in the fall of 2018. Drawn out trade negotiations, Brexit and U.S. government shutdowns are all moving dynamically and hard to handicap. Sprinkle on the healthy dose of financial market volatility during December and January and the Fed decided to hide behind a wall of well-behaving inflation and change its stance.

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Unfortunately, this change of heart comes at the cost of further progress on points two and three previously mentioned and risks further market volatility down the road. If the U.S. economy is as healthy as Powell portrayed in his press conference, then the Fed just fell behind the curve.

Breaking Down Last Week’s Messaging

Last week the Fed tried to communicate they are in full data dependency mode. What everyone heard, and what the markets quickly priced in, was that rate hikes are done for the foreseeable future. Additionally, they made it clear they are willing to stop shrinking their balance sheet. They also made a point of including the following text in a post meeting press release regarding balance sheet policy:

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“The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.” -FOMC statement January 30th, 2019

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Compare the above with this statement made six and a half years ago on July 26, 2012 by Mario Draghi, the longtime Head of the European Central Bank (ECB):

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“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

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From our perspective, the Fed’s message is inconsistent. It does not match the economic outlook Powell spoke to during his January 30th post-FOMC meeting press conference. It also has a close ring to the Draghi statement which was made to save the Euro in the height of the southern European meltdown in 2012. Why did the Fed choose to go through the effort of reminding everyone they have a bunch of big weapons when there is no crisis in sight and their outlook on the U.S. economy still has a positive bias? Forget about Fight Club – it’s like bringing nukes to Book Club.

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All we can surmise is either the Fed is much more worried about the possibility of a recession than they are willing (or scared) to divulge. If that is the case, then the expectation for zero rate hikes in 2019 is valid. Conversely, if the Fed starts to walk back their late January statements, they have set the markets up for another unnecessary bout of volatility.

Take a Walk

In Zion National Park there is a famous hiking trail, Angels Landing. After the ascent, hikers walk a narrow spine with steep drop-offs on both sides. From this 1500ft high vantage point, hikers can see rock climbers appearing like spiders as they cling to the sheer rock face.

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After last week’s Fed meeting, we are left to question if Powell is a hiker slowly navigating his way on an increasingly narrow trail or a rock climber scaling the mighty wall. No matter the choice, the margin for error is shrinking while the costs associated with a policy mistake are compounding. The Fed has painted itself into an extremely tight corner and operating monetary policy is now contingent on well behaved inflation.

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After being enamored with Jerome Powell and his communication expertise, he leaves us with a lot to be desired after January 30th. Time will tell if the Fed folded like a lawn chair, but we have moved from a position of absolute trust in Powell’s style to “trust but verify.” We will give him another chance or two before jumping off the bandwagon completely.

Where Have You Gone, Jerome DiMaggio?

The tide of easy money swept out to sea in 2018 as the Fed continued to tighten monetary policy. With excessive liquidity draining from a financial system now saddled with historically high debt levels, market valuations will continue to recalibrate in 2019.

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Last April we wrote about a transition that was taking place in U.S. equity markets. Namely, we could feel the decade-long, buy-the-dip strategy was no longer the default option for investors. A sell-the-bounce mentality was starting to take precedent. With a boost from fiscal policy (deficit financed tax cuts and increased government expenditures), it seemed as though nothing could get in the way of positive sentiment within the riskier asset classes during much of 2018. But something happened late in the year on the way to nirvana. Whether it was Brexit worries, tighter monetary policy, tariff tantrums, or inflated Price-to-Earnings ratios, reality set in and confidence collapsed.

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And this is where the rubber meets the road: confidence drives markets and transition periods are ultimately tricky as markets appear schizophrenic. One day the confidence is back only to disappear within hours. Where investors spent nine years trained to buy-the-dip, the mentality is now changed to sell-the-bounce.

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As we enter 2019, there are several stories worth watching. Whether it comes from a Brexit resolution or an end to the U.S./China trade war, a reduction in uncertainty should provide solace to the markets. Investors will still have to deal with the Federal Reserve raising rates in 2019. While the Fed has lowered its signal to two rate hikes this coming year, those calling for one or zero may be missing the point. The Fed, with sufficient cover, must continue to raise rates to gain as much ammunition for the next recession as possible. Speaking of recessions, we continue to believe the current expansion will become the longest on record; however, we have continually targeted 2020 as a potential tipping point and our view has not changed.

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So what does that mean for investors? Markets historically overreact. Deciding where longer term value lies in particular asset classes is an important first step.

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Short term interest rates above 3% would be an example, as would a 13-14% P/E ratio for large cap stocks. Once one has picked levels in a “buy zone,” having the liquidity to take advantage of market downdrafts is a must. With equity markets significantly off their highs and in bear market territory for the first time in ages, we will be looking for opportunities as 2019 progresses.

The U.S. Economy

The story here is little changed. We saw deficit financed tax cuts and increased government expenditures combine to bolster economic activity last year. The positive impulse from expansionary fiscal policy will fade during 2019. There is chatter of an infrastructure plan with the Democrats now in control of the House, but any plan would have to be financed, making it a harder sell given current deficit dynamics. We will wait for more out of D.C. on this front before factoring into our outlook in a meaningful way.

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Monetary policy is clearly less accommodative as the Fed has continued with interest rate hikes and quantitative tightening. We expect the Fed to follow-through and deliver two more rate hikes in 2019. With that said, tremendous market volatility and/or a swift deterioration in economic data would force the Fed to reconsider. Alternatively, the outlook for inflation would have to change materially for the Fed to deliver more than two. This outcome is hard to envision given slowing global growth, low oil prices and a strong U.S. dollar. The Fed will be closely watching wages and inflation expectations as they look to fine tune their expectations for future policy. With that in mind, we expect to see two rate hikes during 2019 with any potential variation erring to the downside.

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Meanwhile, broader economic indicators have generally fared well, with only pockets of weakness (housing in particular). We still see solid economic performance, but caution against over-analyzing available data at this point in the business cycle given the lagging nature of most data series. Business surveys on the manufacturing and service sectors are elevated at levels consistent with further economic expansion. Consumer surveys indicate a still-confident consumer, however, the gap between current conditions and future expectations is at an uncomfortably high level. The bright spot remains the U.S. labor market. Job creation is robust, unemployment is low and initial claims appear to be anchored at historically low levels. Anecdotally, reports of tightness in the labor market are widespread, which should continue to put modest upward pressure on wages.

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In summary, we see sufficient momentum in the U.S. economy for the current expansion to overtake the 90’s as the longest expansion on record. Fiscal policy will be a declining tailwind as the lagged effect of tighter monetary policy will begin to filter through the economy. U.S. trade policy remains a wild card and our view here is unchanged. Further escalation will work to punish the U.S. consumer and weigh on broader economic activity.

A Little More On Trade

The market’s voice was clear and concise in response to presidents’ Trump and Xi November G20 meeting: lip service isn’t going to work anymore. Risk markets are not going to be willing to mount a sustained rally without a solid, agreed upon plan. Even in the unlikely event that the U.S. and China hammer out a truly mutually beneficial trade deal (one that also appeases the markets), any sustained move higher in equities will likely be viewed as a selling opportunity. Investor sentiment shifted in the back half of 2018 and it’s hard to find a catalyst that is going to send risk assets materially higher.

Time As A Healer (Not A Suppressant)

It is going to be paramount that investors allow for the passage of time to act as a healer but not a suppressant. The wounds from 2008 and 2009 have hopefully healed, but their lessons cannot be forgotten. If we learned one thing from the most recent financial crisis, it is that excesses create imbalances and imbalances create pain, regardless of the system. The human body is a great example of this fact. Excesses in one part of the body create an imbalance elsewhere; before you know it, you’re on the phone making an appointment with a physical therapist. Of course, these imbalances wreak havoc exponentially with age, sparing sprite youths of such mundane aches and pains. Clearly we are talking about the U.S. financial system and a business cycle that is aging. It would be foolish to think that the excessively easy monetary and fiscal policies in recent years have not contributed to imbalances.

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We have argued for years that a portion of the move higher in risk markets was unfounded and supported by excessively easy monetary policy. As the Fed began to reverse the easy monetary policy, the U.S. economy was hit with politically motivated and ill-timed fiscal stimulus. This expansionary fiscal policy only worked to pull forward future consumption and will have significant future cost associated with it. Down the road, capital will have to be used to make ballooning interest payments instead of more productivity elsewhere in the economy.

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Let’s not overthink this one: unprecedented monetary stimulus followed by a sizable, inopportune expansionary fiscal package caused excesses. Excesses lead to imbalances and imbalances cause pain. Or, said differently, as the easy policy trade unwinds, the magnitude of the down trade could be more severe than most expect.

Looking Forward… Focus On The Long Term Goal!

As we move through 2019, we advocate a healthy dose of caution. The outlook over the intermediate term has become decidedly more uncertain and warrants careful consideration. However, just because thunderheads are on the horizon does not mean that it’s time to panic. In our opinion, market timing is not a winning strategy. Therefore, those who remain disciplined and add exposure when value presents itself will achieve their strategic goals in the long run. It’s a marathon, not a sprint.

High Yield Bonds – A Critical Component Within Captive Insurance Portfolios

Over its almost 40-year history, high yield bonds have evolved from a niche corner of the fixed income market to a fully mature sector utilized by many investors. However, even with a total outstanding value over $1.2 trillion, the high yield market seems to elicit more love/hate posturing than almost any other sector. Perhaps by virtue of its hybrid nature – looks like a bond but acts like a stock – high yield bonds will always collect groups of naysayers with an opposing view. Whether it’s an argument that high yield bonds do not yield enough or how they will react to future economic and broader market conditions, it seems the haters are entirely more vociferous. While other investor types may have their own assessment of the high yield market, Performa views the asset class as an integral part of captive insurance portfolio asset allocation. Early stage captives should view high yield bonds as the next logical step once surplus accumulation begins. Meanwhile, those entities with significant surplus should be availing themselves of all high yield has to offer as a tool to manage portfolio risk between traditional investment grade bonds and more volatile equity exposure.

High Yield Characteristics

In form, high yield bonds are no different than their investment grade corporate bond counterparts that are a staple in many captive portfolios. In purpose and structure, both markets exist to lend money to companies for a variety of uses. The differences between the two, however, are the types of risks and expected returns that a bondholder takes in each category. High yield issuers have lower rated creditworthiness (below BBB ratings level) and subsequently pay higher yields to investors. The consequence is that the high yield market provides a more idiosyncratic return to investors; performance is impacted more by individual issuers and certain sectors rather than the direction of interest rates and corporate bond spreads relative to U.S. Treasury bonds.

A Sprinkle Of Equity Risk A Day Keeps Some Interest Rate Risk At Bay

Given that high yield bonds trade primarily on credit risk (as opposed to interest rate risk), the sector can provide diversification benefits when coupled with other bond and equity strategies. For a captive that is beginning to take on more risk, an allocation to high yield bonds can provide an equity-like return, but with less volatility, while diversifying away from interest rate risk. For a mature captive with multiple asset classes, high yield can provide a middle ground between investment grade bonds and equities from a risk and return perspective.

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Diversification is a sizable benefit, as is the ability to use a high yield allocation as a tool when adding or reducing overall portfolio risk. In either case, the diversification comes from less correlation (movement in tandem) between credit risk and interest rate risk. Roughly 35 years of data demonstrates that high yield exhibits low correlation (between 50% and 60%) to investment grade corporate bonds and equities. As for interest rate risk, high yield barely follows as its correlations to U.S. Treasuries and Government bonds are less than 10%.

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While diversified risk is good, it is only useful if returns are commensurate. Indeed, from July 1983 to November 2018 high yield has produced annualized returns of 8.75%, which was comparable to the S&P 500 and Russell 2000 returns of 10.89% and 9.03%, respectively. What is more telling however, is that over the same time period high yield posted a dramatically lower standard deviation of 8.19% compared to 14.62% for the S&P 500 and 18.82% for the small cap Russell 2000 Index. In other words, high yield has largely kept pace with equities while capturing only roughly half of the volatility (as measured by Standard Deviation).

The Power Of The Coupon

Bonds with higher coupons can act as a buffer for times when riskier assets (such as stocks) become more volatile or when interest rates are rising. Higher coupons of high yield bonds (interest payments) can help offset negative price movements. In 2014, the high yield market fell more than 4% on a price return basis, yet its total return for the calendar year was a positive 2.45%. Since the yield of the market at the beginning of 2014 was almost 6.6%, there was more than enough income received by bond holders to offset the negative price action. Meanwhile, in 2013, the high yield price return experienced a negligible gain of 0.11%. However, a healthy coupon return of 7.34% provided investors with a total return of 7.45% for the year. 2013 was also the year in which interest rates rose across the yield curve, leading to negative total returns for several investment grade bond benchmarks. For example, the Bloomberg Barclays Intermediate US Government/Credit Index generated a return of -0.86% while the Bloomberg Barclays US Aggregate Index was -2.02% for the year.

Interest Rates On The Up And Up

Since Q4 2001, there have been 15 periods when the yield on the 10-yr U.S. Treasury had risen more than 50 basis points. During those periods of rising interest rates, the high yield market generally performed quite well, producing positive absolute total returns in 12 out of 15 instances and outperforming investment grade bonds 14 out of 15 times. Part of that has to do with rising rates being indicative of an improving economy which is usually better for lower quality bond issuers as well as stocks. Rising profitability and balance sheet improvement is especially relevant to high yield issuers as they gain greater flexibility to refinance their existing debt at lower yields and may even become investment grade credits (rising stars). Overall, a rising economy is an environment where bond defaults should remain subdued and investor demand should be supportive of spreads.

Conclusion

As 2018 comes to a close, the U.S. economy remains in its second longest expansionary period on record. Year-to-date default rates (see Chart 4 below) through November 2018 fell 0.17% to 1.87% and remain well below the long-term average of ~3.5%. Stripping out iHeart Media’s $16 billion default earlier this year, the rate is only 1.14%. Leverage ratios remain in check and upgrades continue to outpace downgrades, all of which should remain supportive of credit as long as company earnings stay upbeat and the economy continues to chug along for the next few years.

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The high yield market should continue to benefit from muted new issue supply as a large portion of the new issuance market is either refinancing existing debt or refinancing into the high yield loan market. While there will always be cyclicality in prices and yields across bond markets, and in the high yield bond market in particular, the sector has proven throughout multiple cycles that it should be an integral part of a client’s asset allocation strategy. An actively managed high yield bond portfolio that seeks to preserve principal by managing credit risk can provide good diversification and low correlation amongst other fixed income and equity strategies. Additionally, the sector provides attractive risk adjusted returns and lower sensitivity to changes in interest rates, which is especially important in a rising rate environment.