The S&P 500 began 2016 by posting the worst start to a year, ever. The downturn continued for most of February, reflecting the fear of global recession prevalent among investors. However, March brought a welcome respite from the market volatility experienced in January and February, with domestic equity markets ending the first quarter relatively flat. The S&P 500 returned 0.4 percent year to date, showing we’ve come far from that initial volatility. However, volatility is likely to resurface again this year.
The global economic environment hasn’t changed dramatically, but investor reaction to market news has changed quite a bit. From mid-2012 up to 2015, domestic equity markets were predominantly in an uptrend, which is a stark contrast to the up-and-down pattern we’ve seen of late.
In addition, it’s an election year. Historically, the most common pattern is for the market to stay flat or drop until August, appreciating only afterward. A potential explanation is that the market hates uncertainty, and by August the country generally has a good idea of each party’s candidates and the direction the United States is leaning with respect to the White House and Congress.
At the point of this writing, the S&P 500 has gained about 1 percent, corresponding to the historical election-year pattern. Moreover, the forward price-to-earnings ratio of the index is 16.62, which is above the historical average of 15.38, but market consolidation has already moderated the valuation metric from last year’s mark, which was over 17 times earnings.
In our view, the recent stock market vacillation represents a pattern of consolidation, which implies a good degree of uncertainty. But going forward, this is usually constructive. While consolidation represents market uncertainty, it provides a breather, allowing company earnings to catch up to stock prices and resulting in moderated valuations.
The market drops last year and this year were similar to the past because they reflected investor concerns around the sustainability of global growth. What differed was the cause of this decline, which was an interpretation of currency market action. Understanding the primary cause of the decline provides the perspective to more accurately assess the validity of the market’s reaction and potential future outcomes. This is significant because market declines are normally based on contraction of company earnings, deteriorating credit conditions, or rising interest rates—not the result of an interpretation of currency movements. Currency movements, in the short run, can seem irrational due to activities such as hedging or short covering, which cause the currency to move counter to logic. This may be the reason they don’t normally result in stock market sell-offs.
The spark that set the fire was China’s decision to let the yuan, which is pegged against the US dollar, depreciate more than anticipated. Investors interpreted the government’s decision as a sign that China’s growth was slowing more than the data was showing, so the government was desperate to stimulate growth by weakening the yuan to boost export growth.
There’s already a high degree of distrust among capital markets regarding Chinese economic data, and investors were predisposed to assuming Chinese growth was weaker than portrayed. This assumption led investors to fret about the sustainability of global growth, which resulted in recent market declines. Given the market’s lack of confidence in Chinese economic data, investor interpretation of the Chinese government’s decision to weaken the yuan wasn’t illogical, but we believe the reaction was exaggerated.
As mentioned, China pegs the yuan to the US dollar, which has appreciated significantly in the past two years, so the yuan has also risen in value. Yuan appreciation has negatively affected Chinese export growth, and overall economic growth as a result. Because the trend and outlook for the US dollar is continued strength, it seems sensible for government officials to allow the yuan’s value to drop—potentially lower than warranted—to avoid having to do so again in a relatively short span of time.
The important point is the market potentially overreacted. We think the market mistakenly placed too much emphasis on Chinese growth being much weaker, which was the primary motive for depreciating the yuan, instead of considering other reasons such as other global economic data.
When volatility hits, money goes into bonds—and this sends the yield on the bond lower. Bond prices and yields have an inverse relationship: as bonds increase in value, the yield is driven lower and vice versa. For example, consider a bond trading at par (the amount received at maturity), which is $100, that has a coupon of 4 percent and matures in five years. In each year up until the year of maturity, the investor expects to receive an interest payment of $4, which is 4 percent of $100. In year five, the bond matures so the investor receives $104, which is the $100 par value plus the 4 percent interest payment. If interest rates rise to 5 percent, the effect is a price decline of 4.4 percent to $95.60, effectively increasing the yield to 5 percent to match the existing interest rate.
At the end of 2015, the yield on the 10-year US Treasury note closed at 2.3 percent, and the consensus expectation at the time was to end 2016 at 2.75 percent. What materialized was an immediate drop in its yield; it dropped below 2 percent by January 20. After a brief pop above the 2 percent threshold, we haven’t closed above that mark since January 28. March 11 was the closest the yield came to 2 percent, closing at 1.99 percent, and the 10-year note is currently yielding 1.73 percent.
The yield remaining depressed is somewhat confusing for future implications, considering the stock market has rallied past the previous high of the year and is approaching all-time high levels. Additionally, both the headline and core (food and energy, for example) inflation readings, as measured by the consumer price index, have risen this year, which should also portend an increase in the 10-year Treasury note yield.
We view the low-yield environment, especially when considering the aging demographic in the global regions where wealth is concentrated (particularly throughout Europe and the United States) as reasons to favor risk assets such as stocks, high-yield bonds, and real estate investment trusts (REITs).
As the population in these regions age, many rely on investment returns to fund their lifestyles. When these investors can’t achieve their required return from traditional bond markets, they’re forced into purchasing riskier assets with a greater portion of their portfolios, effectively increasing the value of risk assets, either faster than normal or beyond fair market value.
Owning a greater proportion of riskier assets is a dangerous game. Most investors know high-yield bonds or equity income securities, such as REITs, are more volatile than higher-rated bonds, which can make these investors more nervous about losing principle. Heightened nervousness among these investors, especially the longer the situation persists, makes them more inclined to sell early to avoid being the last one to exit. It’s logical that the increased prevalence of this type of investor will likely result in increased market volatility.
The Federal Reserve isn’t likely to dramatically raise interest rates due to our current slow-growth mode. Prior to 2000, gross domestic product (GDP) growth in the United States averaged roughly 3.3 percent. Today the average has fallen to approximately 2.5 percent. On a national level, the forecast is to spend more in the next five years, primarily due to entitlement programs, such as Medicaid, Medicare, and Social Security, as opposed to projects that can add to future growth. Federal spending increases to an already-bloated balance sheet in an economy with tepid growth isn’t a recipe that leads to increasing interest rates. Increasing interest rates could result in higher taxes for individuals or more debt issuance to fund rising interest costs, which doesn’t make much sense.
Now, the Federal Open Market Committee (FOMC), the government body that determines the direction of interest rates in the United States, is stuck in a hard place. It feels the need to increase interest rates because they’ve been historically low for over a decade, but that’s balanced by its desire to stimulate the economy by lowering rates during the next economic downturn. However, raising interest rates in the current economy entails an elevated risk of causing the next recession by choking off growth much more than holding rates steady.
On aggregate, earnings growth rates for companies in all industries have slowed and profit margins, which have been at or near all-time highs for a longer-than-anticipated period, are starting to get squeezed. Revenue growth, meanwhile, hasn’t been robust and isn’t showing signs of gaining momentum. Although the picture we just painted isn’t exactly rosy, it also doesn’t paint a dramatic market downturn either. In fact, when viewed in this context, the consolidation pattern among the domestic equity market appears to make more sense.
Another reason we’ve been steadfast on a persistently low-interest rate environment is the relative value of US Treasury issues versus debt issuance by nations of similar credit ratings. Europe and Japan currently have negative interest rates within their yield curves, and longer-term issues in those markets have paltry yields. This makes US Treasury debt all the more appealing and in high demand. As long as the relative value is there, demand will remain high and keep interest rates suppressed.
Volatility will resurface. We think the domestic stock market will provide mid-single-digit returns at best. Income investors will have to continue to lower their credit standards or extend the maturity of their portfolios to generate adequate income. Currently, we feel the best opportunities within the capital markets exist in the following areas:
- Bank loan or leveraged loan market
- European equities
Here are some other options as well:
- Municipal bonds. This looks very good from a spread basis. You’re compensated better than in the Treasury markets. Credits are working their way into municipal markets because property markets keep going up and assessed value isn’t reflected for many years. As assessments go up, property taxes go up, which means municipalities look good and are improving. Municipal bonds look favorable and are trading at premiums now—yields are low, it’s tax free income, and it’s stable. We don’t see this demand abating.
- High-yield bonds. When there’s fear of a recession, high-yield bonds sell off because people think default rates are going to increase. The yield was 9.24 percent at one point. The spread was 831 basis points on February 12 and now sits at about 660 basis points. That’s a big move in one month. Higher spreads reflect a higher default risk. To give perspective: The spreads reached 1,900 basis points at the height of the financial crisis.
Investors are willing to take the risk of a high-yield bond for a 9 percent yield compared to the 2 percent received from US Treasury bonds. While they might not understand the level of risk, investors need that return in their portfolios. While we think this course of action will persist, we’re also seeing a common trend: fear is a powerful driver for buying and selling at the wrong time.
We're Here to Help
For additional insight on how your portfolio may be impacted by interest rates or other economic conditions, contact your Moss Adams wealth advisor.