I re-read my Q2 2016 commentary entitled, Central Banks Playing Chutes and Ladders. What was written back then still applies today. The Fed continues to measure economic data, some good (Ladders) and some weak (Chutes) and adjusts monetary policy towards full employment and 2% inflation.
The result has been that after hiking rates for the past several years, the Fed has been forced to reverse course and start an easing cycle. In Q3 2019, a peak in global negative bond yields reached $17 trillion by some estimates. The “don’t fight the Fed” mantra of so many past bull markets is losing its effectiveness as we sit at these low levels of interest rates.
Stocks have moved higher over the last two years, but it has been the combination of monetary and fiscal stimulus in the tax cuts that have driven the equity markets higher. The stock market’s wealth effect has aided the continuation of the economic expansion, which is now in its 10th year.
The negative interest rate siren continues to call with its allure of free money. I don’t think it’s a coincidence that the malaise of the Japanese and Eurozone economies is partly due to negative rates. On June 16, 2016 German 10-year bonds turned negative and the Eurozone arguably has stalled in its attempts at economic recovery.
Sometimes I believe that it is just simpler than economists make it out to be. The communitive property was taught to me in 1st or 2nd grade:
If: A>B and B>C
Let’s apply this to the simple world of the consumer:
- Car loan at 4% (A) > owner ability to pay
- Car Loan at 2% (B) > owner ability to pay
- Car Loan at 0% = owner ability to pay…huh?
It doesn’t make sense except to create a world where the consumer is over-indebted and is spending beyond their means. Therefore, when C is a transaction financed at zero rates, it possibly means that the asset is overvalued to begin with. It’s as simple as the communitive property.
Let’s apply this to our management style in an ever-increasing global negative rate environment with an active Fed.
If: Positive rates > negative rates
Active management > ladders
Then: Actively managed positive rates > ladders in negative rates
Yields continued their trend lower in the third quarter as the 2-year Treasury rallied from 1.78% to 1.63%. The 10-year Treasury rallied from 2.02% to 1.68% by quarter end according to Bloomberg data. The lower yields resulted in a tighter 2 to 10-year spread, continuing the trend toward a flattening of the yield curve. The bond rally resulted in the Bloomberg US Aggregate Bond Index returning 2.27% and the Bloomberg Barclays Intermediate US Corp Index up 1.74%.
Returns in the quarter were driven by:
- A barbell strategy that has been underweight 2 to 3-year duration bonds relative to its benchmark and overweight 7 to 10-year duration bonds relative to its benchmark.
- The strategy has been overweight Communication Services, Consumer Discretionary, and Energy versus the benchmark, which have been positive drivers of performance.
- The strategy has been underweight REITs and Utilities. REITs are approximately 4.3% of the benchmark and have been the best performer in the benchmark year-to-date. Our underweight position in these two sectors has caused some drag in the portfolio.
- Investment grade credits spreads remain firm and high yield continues to provide additional coupon income in our BB credit holdings.
Quoting from a Bloomberg news story, Standard and Poors has taken its most bearish stance on U.S. Corporate debt since 2015. According to S&P, 164 issuers were downgraded and 64 were upgraded. Of the issuers that were downgraded, 143 of them were in the high yield sector. In the investment grade space, there were 31 upgrades versus 21 downgrades. In our opinion, this is most likely due to the slowing U.S. economy and it seems logical to be contained more to the high yield sector.