Key Takeaways of 2018 Q1 Investment Letter
- Equity and fixed income markets were both slightly negative in Q1 2018, while alternative managers were slightly positive.
- Risk and volatility are increasing, so are fixed income yields as the US Treasury issues significantly more debt.
What a difference a (new) year makes. With a rise in volatility and headlines about macro and market risks, the S&P 500 was negative in February and March, ending the first quarter of 2018 down -.76%. Fixed income markets were generally down in concert with equities as the Barclays Aggregate Bond Index returned -1.46%. 1994 continues to be a potential lens through which to view 2018 – namely, a surprising co-existence of 1) strong corporate earnings, 2) negative stock returns, and 3) a rise in rates and decline in fixed income markets. While we await corporate earnings for Q1, analysts are still predicting robust earnings growth of +25% for the year. Thus far, 2018 is indeed playing out similarly to 1994. The one bright spot was our Alternative managers where three of the four holdings were positive. Putting it all together and depending on risk profile and vehicles chosen, most portfolios were down somewhere between -.50% and -1.25% for 2018 Q1.
While some risks have dissipated from the headlines in 2018 (e.g., nuclear confrontation with North Korea), more than enough others have taken their place. We believe the one with the potential for most impacting your portfolio is the concurrent ending of the Fed’s decade long Quantitative Easing programs with the US Treasury’s need to issue increasing amounts of debt to fund the deficits, exacerbated by the recently passed tax legislation. In fact, as I write this, the Congressional Budget Office (CBO) announced they are bringing forward their timeframe for annual $1 trillion+ deficits from 2022 to 2020, a 50% increase from 2017’s $665 billion deficit. As recently as 2015, the annual deficit was less than $500 billion. So we have increasing supply of government debt and a large and importantly price insensitive buyer (the Fed) backing away. Market participants talk about Treasury issuance potentially “crowding out” other borrowers, like corporations, state and local municipalities, and asset based structures. Private fixed income investors (as opposed to Central Banks) need not just their customary spread over risk free Treasuries to buy the other debt, but need even more spread as their fixed income portfolio is overweight Treasuries, thus “crowding out” their desire to own other fixed income.
We see this in the increase in LIBOR, arguably the interest rate against which more debt is priced than any other. Not only has LIBOR increased (as we would expect given the general rise in interest rates) but it has increased versus Treasuries as well. Financial observers often see more information in the spreads of one asset to another than the absolute value of such assets.
Spread of 3 Month LIBOR yield over 3 Month Treasury yield
Impacts on Portfolios and Role of Fixed Income
We remain vigilant on the risk noted above and on others. With an eye toward the potential for increased volatility, we increased our exposure to active fixed income last year as well as added an active alternative manager earlier this year. A natural question someone who has read this far may have is, “You have spent so much of this commentary talking about the potential for a rise in rates, shouldn’t we think about trimming our bond exposure?” To that we say no. Fixed income serves multiple important roles in a diversified portfolio: long term positive return with current yield, portfolio diversification away from equities, and a ballast in volatile market environments. While the proverbial “past performance is no indication of future returns” is warranted here, the worst year for the Barclays Aggregate Bond Index since 1977 was 1994’s -2.92% decline. We have already had three weeks (and two separate days!) this year where the equity markets declined by more than that. Further, as our core fixed income holdings are high quality bonds, the likelihood of permanent impairment of capital is low. In fact, unlike equities which can decline and stay down for long, unpredictable periods of time, we know high quality fixed income portfolios will revert back to their original value given an interest rate shock. They will do so prior to the effective duration of the portfolio. Further, the portfolio will have more value, even considering the initial shock, by approximately the time of the duration as re-investments are made at the now higher interest rate. With our core models having a duration of ~ 5 years, we may not like the paper loss, but we take solace in knowing our fixed income portfolios should get back to even before then and be worth more soon after. As long as your investment horizon is longer than this ~ 5 year duration, you should welcome a rise in rate. Bond math is a wonderful sedative. What we would suggest, as we did in our Year End letter, is to think hard about your risk profile. After years of both equity and fixed income markets producing robust gains, you cannot expect that to continue. If you opened your first quarter statement, saw a negative number and had to sit down, maybe you should revisit your risk tolerance.
Our Market Observations
- US and international economies continue to expand in parallel for the first time since before the global financial crisis, albeit at a slightly slower pace than earlier this year. The OECD is predicting global GDP to grow +3.74% in 2018, up from 2017’s +3.58% before moderating to +3.62% in 2019. We agree and see steady, albeit not stunning, global growth.
- The “softer data” is coming in OK but weaker than earlier in the year. For instance the US Small Business Confidence index has come off its highs and the Citi Surprise Index for the US has fallen from a robust 84.50 to a still good but lower 49.80.
- Macro, political risks and the “unknown unknowns” have increased and are elevated.
- Decade(s) long regimes in place are showing signs of ending, introducing yet further uncertainty. The Fed’s ending of QE and the potential end of the USD as the sole currency for the global oil trade are two we are following in particular.
- While not the only measure of uncertainty, the equity based VIX index averaged over 17 for the first quarter, up from an average of 11 last year. We expect volatility to remain elevated.
- Portfolio managers we speak to say the companies they follow were universally positive on the recently passed tax legislation and the companies were the most bullish on their own prospects in years. However, those same portfolio managers caution us to listen to see how much is mentioned in Q1 earnings calls about renewed uncertainty around trade wars.
- The increase in yields on Treasuries has largely been at the front end of the curve. Since the end of 2016, yields on 3 year maturities and less have risen 100-125bps, 10 year yields have risen 40 and 30 year yields are actually down a bit. To us, short and ultra-short duration fixed income looks attractive for the first time in a decade. We are actively reviewing potential new managers who focus on this part of fixed income markets.
Current US Treasury Curve (top line) and US Treasury Curve as of 12/31/2016 (bottom line), absolute level of changes in rates in bottom bar charts
- Historical economic models around the correlation of 1) output gaps and unemployment to 2) inflation have broken down as the latter has not picked up as expected. Powerful dynamics are pulling in opposite directions in the inflation tug of war. We remain on the lookout for any changes and if such changes compel modification to our asset allocation.
As always, please reach out with any questions, concerns, counter-arguments.
Chief Investment Officer