Not the Time to Chase Certain Investments
Following the U.S. election, equities have hit all-time highs as U.S. stock indices price in stronger growth in the U.S. economy and potential policy shifts that would benefit corporate bottom lines. The “reflation trade” that has benefitted stocks has been accompanied by an increase in U.S. Treasury yields, damaging many “safe” fixed income portfolios. The ten year treasury rate is now higher than where we began 2016, and could move meaningfully higher in 2017 from these historically low levels. The markets don’t have a shortage of uncertainty, but given the increase in price for risky U.S. assets, markets are looking through the uncertainty and giving the new administration and the strong underlying economic fundamentals the benefit of the doubt.
I attended two conferences in the past week the Wells Fargo Middle Market Conference and the Goldman Sachs Credit Outlook Conference. Both conferences focused on trends in credit markets and gauged the sentiment of fixed income investors. At both events, money managers, economists, and market strategists remain cautiously optimistic, despite the uncertain direction for policy. The labor market remains healthy, with unemployment dropping to what many economists consider below full employment. U.S. Tax reform looks like it will be tackled early in the next administration, and could be a boon to U.S. businesses. Generally, market prognosticators expect some greater volatility but see the backdrop of a strong U.S. economy unless derailed by exogenous domestic and geopolitical shocks. Thus, most strategists I heard are predicting a volatile path to modestly higher levels for risky assets in 2017 and overwhelmingly favor interest rates moving higher.
We remain positioned for higher interest rates, by keeping our portfolio duration very short. We still view interest rate risk as the primary risk to fixed income portfolios. Long duration asset portfolios offer even less appealing returns today for the risk assumed than ever before. Our approach served clients well when rates spiked. However, it causes a perpetual dilemma as securities are converted to cash at a rapid rate in a short duration bond portfolio. Faced with reinvesting proceeds from matured bonds in a market where rates continue to move higher.
Moreover, risk spreads have narrowed, as the economy is expected to perform better and profits rise for companies with plenty of debt on their books. As a result, interest rates on high yield bonds have risen more slowly than on investment grade bonds, most notably for Treasuries. Having performed relatively well, high yield bonds now also have more risk relative to rising rates, more like their high grade alternatives. There are still pockets of value within U.S. fixed income assets, but investors need to become far more selective due to the heightened risk.
Higher prices for risky securities leave many managers chasing the investments they missed this year. As stocks have hit record highs, high yield bonds have also rallied, even as Treasuries have fallen sharply. We are avoiding this psychological pitfall and choose to remain cautious and focused on the risks we can control (interest rate, credit, liquidity) for clients. The dilemma is further complicated by the fact that we see the current business cycle extending through its seventh year, yet we now share widespread expectations for tighter monetary policy in 2017. Unlike others, we suspect interest rates may rise considerably further, but this is not widely shared. In acknowledging this uncertainty in light of the facts visible in the market, we remain cautious in putting cash to work and refuse to chase securities where the return does not justify the risk.
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