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Dangers Lurking in the Bond Market

 

April 19, 2018

By: Darren P. Wurz, MSFP

Rising interest rates, inflation worries, trade wars, corrections, bear markets—it's amazing how quickly the market conversation can change. In my last newsletter, I warned that 2018 might be different! And it certainly has been. While everyone has been focused on the equity markets, which have consumed headlines, it's the bond market that I've been paying more attention to.

“[Bonds] are among the most dangerous of assets. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal.”5

—Warren Buffett

 

The first quarter showed just how volatile and nasty the bond market can get when interest rates threaten to rise quickly. In the first quarter, the Bloomberg Barclays US Aggregate Bond index was down 1.46%. The S&P 500 was down 0.76%1. Even though the stock market is grabbing headlines, its actually the bond market that has done worse!

There are several dangers lurking in the bond market that may prove to be challenging in the near future. The first of those is the prospect of higher interest rates. The Federal Reserve is on a rate-raising path, with several more interest rate hikes expected this year. When rates rise, prices of existing bonds lose value. How much?

Here's an example. Bonds have two important numbers: a price and a coupon rate. The price is how much you pay to buy the bond and the coupon rate is how much interest you'll receive. So let's say you bought a bond for $1,000 (at par value) that has a coupon of 2.5% (so you'll get $25 a year in interest payments) and it matures in 5 years. A year later, let's say interest rates rise and now investors are demanding a 3% yield on bonds like the one you bought. What is your bond worth?

$984.20

That's a 1.58% reduction in value on a 0.5 percentage point rise in interest rates. If interest rates double to 5%? The value of the bond falls to $915.78. That's an almost 9% drop in value.

Rising interest rates will have other effects as well. When interest rates increase, companies have to pay more on new debt that they issue. As old debt matures and needs to be replaced or refinanced, companies have to pay more in interest payments to investors.

Further, the technique of raising interest rates exposes the market to additional risks. How does the Fed raise rates? One way they can raise rates is by raising the interest rate they charge banks to borrow money from the Fed or from each other. The Fed doesn't rely so much on this strategy any more. The Fed actually buys or sells securities in the marketplace to alter interest rates.  To raise rates, the Fed will sell securities. The Fed is unloading massive amounts of treasuries in an attempt to (1) reduce the size of its balance sheet that built up after the financial crisis and (2) raise rates2. Whenever you have more selling than buying, prices drop and this is what may happen to bonds.

Another big problem facing the bond market that no one is discussing is the growing size of the deficit of the US government and governments around the world. By cutting taxes and increasing spending, the Trump administration is dramatically increasing the US deficit. When government debt increases, interest rates typically increase as well because there is more risk associated with a higher deficit. Investors demand higher interest payments to own government debt.

Well this isn't happening—yet. Bond yields have stayed low while deficits are soaring. The graph below shows the correlation between yields and the federal deficit. Since the early 2000s, the two trends have diverged. There is a strong probability that we will eventually see a return to normality, which could mean a dramatic increase in interest rates.

The deficit has other unintended consequences too. How does the government spend money it doesn't have? It borrows by selling bonds. Indeed, the treasury department is ramping up the amount of debt it is selling in the market to unprecedented levels. And the government is having a harder time finding buyers for all this debt3. So not only is the Fed selling treasuries, the Treasury is selling record amounts of treasuries too. This can mean only one thing—interest rates are likely to rise and bond prices may fall.

Finally, how about China? News headlines have highlighted the fact that China is a major owner of US treasuries. And if a trade war with China ensued, China could hurt the US by selling these treasuries. However, ownership of US debt has become more diversified over time. The actual percentage of US debt owned by China is somewhere around 5%. And China's ownership of treasuries has a lot to do with managing the value of its own currency4. So it is unlikely that China would unload its supply of treasuries.

In conclusion, the bond market is facing some very large challenges, which could spell disaster for investors who are holding large concentrations of US treasuries. Conventional wisdom says that investors should increase their holdings of high quality debt (like government debt) as they near retirement to reduce their risk. We believe that investors need to be mindful of the risks in the bond market and explore alternatives for reducing portfolio risk other than a static allocation to government bonds.  At Wurz Financial Services, we believe a a tactical approach to portfolio management that can adapt to market conditions is a better way to manage portfolio risk than a static allocation to bonds. Want to learn more? Call me today!

References

1. Morningstar, Inc.

2. https://www.cnbc.com/2018/03/28/the-fed-and-treasury-is-growing-an-800-disconnect-in-the-bond-market.html

3. https://www.bloomberg.com/news/articles/2018-04-12/lackluster-u-s-bond-auctions-add-to-worries-of-foreign-pullback

4. https://www.investopedia.com/articles/investing/080615/china-owns-us-debt-how-much.asp

5. http://fortune.com/2012/02/09/warren-buffett-why-stocks-beat-gold-and-bonds/ 

Graph: Pantheon Economics

For informational and educational purposes only. Not a recommendation to buy or sell any securities.

 

 

 

Where are the Markets Headed in 2018 and Beyond?

Will the nine year bull market continue? How long can it last? What should we expect over the next decade?

Click here for pdf version

January 24, 2018

By Darren P. Wurz, MSFP

I'm beginning to sound like a broken record: the bull market is aging, it's expensive and there seem to be better opportunities outside the U.S. Sound familiar? That's because this is what I and many others said last year. So what should we expect for 2018? Another stunning run? Most sources that I read are saying this is unlikely. Opportunities may still exist, though, in small caps and non-U.S. markets.

"The four most dangerous words in investing are: 'this time its different.'" --Sir John Templeton

As the bull market enters its 9th year, it is now twice the lifespan of the average bull market. If it survives beyond August, it will be the longest bull market on record. The market is looking more and more expensive. Domestic equities are more expensive than they were in the run up to the Great Depression in 1929 and the financial crisis in 2007. This is the second most expensive market since WWII, the most expensive being March 2000, just before the tech bubble burst.

Despite high valuations, there is still a bullish case to be made for U.S. equities. Corporate revenues are increasing. The economy is growing, although slower than previous expansions. Weirdly enough, this slower pace of growth may be what is preserving this bull market and saving us from the typical boom-bust cycle.

Kiplinger is projecting US economic growth at 2.6% over the next year and forecasts an 8% return for the S&P 500 for 2018 (Smith 2008), on the optimistic end of the specturm. Others are more skeptical. CFRA is suggesting a lower return for 2018, forecasting 5% for the S&P (Stovall 2018). Morningstar did not provide an actual number for 2018, but says they are increasingly skeptical.

Is it time for a downturn? After all, strong economies don't always mean strong markets. We have not had a meaningful downturn since the 14% decline that ended in early 2016. And that wasn't enough to send us into a prolonged bear market.

Signs of a recession are remote, but risks to the markets and economy do exist. Political discord in Washington could harm the economy or harm sentiment in the markets. Geopolitical tensions with North Korea and others could lead to regional conflicts that could spook the markets. As labor markets dry up and inflation picks up, the economy could overheat leading the Fed to increase interest rates faster than expected which would have a dampening effect on the economy. High stock valuations are a risk, of course. And finally, investor complacency is a risk. In the low volatility environment we're in, investors have become more comfortable with taking risk and have been increasing their exposure to stocks.

How should we position ourselves for 2018? It is likely that you will need to make adjustments to your portfolio. After a strong year like 2017, you might find that US stocks have become a larger chunk of your portfolio than you intended. This could increase your risk level and the volatility of your portfolio. You may want to trim back your stock positions to maintain your desired risk level. This is called rebalancing.

CFRA is suggesting that investors should reduce their large cap stock exposure and increase exposure to small caps, which they say will benefit most from tax reform (Stovall 2018). Kiplinger suggests that investors should look to financials and the tech sector, which they claim are poised to outperform in 2018. Banks may profit from higher interest rates, a growing economy and less regulation (Smith 2018).

Others are suggesting that investors look beyond the US to international equities. The case for international equities is strong and investors have been migrating overseas. According to Money Magazine, from March to November, investors moved $65 billion out of US focused funds and moved $150 billion into foreign focused funds.

There are good reasons why investors are interested in international markets. First of all, international equities are cheaper than US equities, especially in emerging markets. Second, the international bull market is much younger, especially in Europe. US stocks have been rising for 9 years, but Europe's economy only started growing in 2013. Interest rates are still low, stimulative monetary policies are still in place and indexes have yet to reach their 2007 peaks in Europe and elsewhere. (Lim 2017).

A third reason investors are interested in international equities is that profits are growing faster overseas and have a lot of room for continued growth. European profit levels are far from record levels, while profit margins for S&P 500 companies have already reached record levels. Finally, the bull market internationally is much more diversified. The US rally owes much of its steam to the tech sector, which has grown to nearly a quarter of the total US market. In Europe, tech represents only 6% of the market (Lim 2017).

There is a lot of pessimism about potential growth beyond 2018. A couple lethal variables may hold global markets back--rising interest rates, expectations of higher inflation, high stock valuations and an aging world population. John Bogle, founder of Vanguard, expects the S&P 500 to average around 4% over the next decade. GMO is forecasting a -5% to -7% return over the next 7 years after adjusting for inflation. Morningstar expects a 1.8% average return over the next 10 years. Charles Schwab is among the rosiest with a forecast of 6.7% future average return for US equities (Benz 2018).

What should we expect beyond 2018? While it is impossible to forecast the future of the markets accurately, it is important to have some kind of expectation to use in planning. The consensus appears to be that returns in the U.S. may be below their historic averages and that growth may be better overseas. If this is the case, traditional buy-and-hold strategies may not suffice. Investors may want to think tactically about how to allocate their portfolios and may need to think outside the box to generate the rates of return they expect and need. If you'd like to talk about your portfolio and explore some of our tactical strategies, give me a call at 859-291-9879.

Sources
Lim, Paul J. (2017) Worried about stocks? Time to run with the bulls in Europe. Money, 46(10), 33-35.
Smith, A. K. (2018) Where to invest in 2018. (Cover story). Kiplinger's Personal Finance, 72(1), 46-53.
Stovall, Sam. (2018) Capping Expectations: Mid- and small-cap stocks boast greater price appreciation potential. The Outlook, 90(2) 1, 8.
Benz, Christine. (January 8, 2018) Experts forecast long-term stock and bond returns: 2018 edition. Retrieved from: http://news.morningstar.com/articlenet/article.aspx?id=842900/

 

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