In early 2009, the U.S. economy was struggling through the worst recession since the 1930s and investors were dealing with an unattractive proposition. They could keep their money in cash and earn nothing, invest in bonds and earn next to nothing, or summon the courage to invest in a stock market that had just declined by 50%. Here we are nine years later and returns on cash have edged higher, 10 year U.S. Treasury bonds yield a measly 2.4%, and the stock market has advanced some 300 plus percent. Now once again, the options for investors appear challenging. What to do?
After a 30 year bull market in bonds and a nine year bull market in stocks, different investors have taken different tacks to the current set of opportunities. Some large institutional investors, such as university endowments, have responded to the low interest rate environment by shunning publicly traded quality securities. They continue to opt for less liquid hard assets like real estate, private companies, and infrastructure projects. Other more aggressive investors, including a few hedge funds and fearless individual investors, have recently preferred to speculate in cryptocurrencies, such as Bitcoin, which have produced spectacular returns to date (more about Bitcoin in separate commentary).
Our investment focus remains on “quality” financial assets since our clients have little use for privately traded assets or fledgling cryptocurrencies like Bitcoin. Of course, quality financial assets, such as highly rated bonds and well financed companies, do have market risk. When investors evaluate the risk of a potential investment, the starting point is usually U.S. Treasury securities. The comparative appeal of U.S. Treasury bonds is based on the belief that they will never default, are not callable, and are easy to purchase and sell in large and small amounts without high transaction costs. The yields on U.S. Treasuries are the standard upon which all other returns are compared. Unfortunately, for investors and savers seeking security, liquidity and reasonable returns, U.S. Treasury bonds still offer miserly low yields.
One year ago, most financial forecasts expected the yields on 10 year U.S. Treasury bonds to increase from these historically low levels. In fact, the 10 year U.S. Treasury yield ended the year essentially unchanged at 2.4%, which is also the same yield it produced in the heart of the recession in 2009. Why no increase in yield? One reason is that a 2.4% yield is relatively attractive compared with yields around the world. Japan’s 10 year bonds have been the lowest in the world at near zero. France and Germany’s 10 year government bonds have been yielding less than 1%. The highest yields in a developed market outside the U.S are in Italy, where you can earn close to 2.0%. So, the foreign appetite of the higher yielding U.S. bonds has been a major factor keeping a lid on yields.
Another attraction to U.S. Treasury bonds is that they are less volatile in price than other bonds and generally less volatile than other financial securities, such as stocks. This lack of volatility has been important to investors, such as large insurance companies, seeking to match bond payments to claims without the volatility of stocks. The preferences for steady interest rate payments and fears of a stock market correction have also attracted individual investors.
In brief, bond investors have enjoyed the bull market of a lifetime with relatively little volatility. Unfortunately, that bull market has resulted in unattractive yields that make the outlook for future strong returns unlikely. In the past three years, for example, as yields have come to rest in the 1.5-2.5% range, the total annual return on the 10 year U.S. Treasuries has been 1.28%, 0.69%, and 2.26% respectively. Obviously, there’s not much to write home about.
We enter 2018 with a similar view to interest rates as we had one year ago. We expect the total return on intermediate Treasury bonds to turn negative over the next few years as a result of the following factors:
Since low interest rates have been a tailwind for stock prices, what will stocks do if rates move higher -- if bond returns are negative, could stock returns actually be even worse? If rates only edge higher with stronger growth, stocks are likely to withstand the higher competitive yields. In fact, stocks could continue to advance with somewhat higher rates based on stronger economic growth that accelerates corporate profit growth. The break point for stock bull markets has always been, however, when interest rates reach a level that dampens economic growth. Many investors are familiar with the ups and downs of stock markets as shown below in the table that summarizes annual returns for the U.S. stock market since 1926. Most of the negative returns in stock markets occur during recessions, frequently on the throes of increasing interest rates. So all eyes are focused on the point at which rates may hamper economic growth.
Total Return of the S&P 500 Index on an annual basis
Positive Greater than 30%
Negative Greater than 20%
Number of years that the annual return was in this range
Positive Greater than 30%
Negative Greater than 20%
The market has produced a positive total return now for nine straight years. We are not predicting a decline this year (like most forecasters, we rarely do), but history suggests we are probably overdue. We were also overdue for a correction when we began 2017, and it did not occur. One of the oddities of the U.S. stock market over the past twelve months has been the lack of volatility as the market advanced every month of the year. The market has now gone over a year without a 5% correction for the first time since 1996.
Why did the market advance so strongly without volatility, and could this pattern continue through this year? We think the aforementioned stability in intermediate bond yields combined with the prospects of greater earnings growth as a result of the cut in corporate taxes kept the wind in the sails of stock prices in 2017.
Beside our focus on interest rate risks, what are the odds that other factors will cause a more severe correction? Over the past year, markets seemed to ignore political and geopolitical tensions and surprises, so it may take a more extreme development in these arenas to upset the apple cart. One area that we remain nervous about would be developments in foreign trade, as NAFTA negotiations and other trade issues are mediated. U.S. investors will be disappointed if U.S. based companies end up in weaker competitive positions globally as an outcome of trade negotiations. By the end of 2018, we should have a better idea of where the U.S. stands vis-a-vis Europe and China in terms of trade positions.
In the near term, we are likely to be taking some profits off the table where we think valuations have largely discounted earnings gains and individual positions have become outsized. We are also opting to raise cash early in 2018 for clients who need to have more liquidity during the course of this year. Otherwise, we will ride through what we expect to be a more volatile year in 2018 on the belief that long term investors are best served by allocating more to stocks than bonds and cash.
Happy New Year!
Chief Investment Officer
The Standard & Poor's 500 Index is an unmanaged broad-based index that is market weighted and used to represent the U.S. stock market. It includes 500 widely held stocks. Total return figures include the reinvestment of dividends. "S&P 500 " is a trademark of Standard and Poor's Corporation.
The Nasdaq Composite Index is the market capitalization-weighted index of approximately 4,000 common equities listed on the NASDAQ stock exchange. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debenture securities.
The Dow Jones Global (ex U.S.) BMI (Broad Market Index) comprises the S&P Developed BMI and S&P Emerging BMI, and is a comprehensive, rules-based index measuring stock market performance globally, excluding the U.S.
The Barclays Aggregate Bond Index is a market capitalization-weighted index. Most U.S. traded investment grade bonds are represented. Municipal bonds, and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and a small amount of foreign bonds traded in U.S.