YTD Benchmark Returns through 9/30/2017
T-Bill 1-3mo (Cash): 0.56%
Barclay’s Aggregate Bond Index: 3.14%
Barclay’s Municipal Bond Index: 4.66%
S&P 500: 14.24%
Russell 2000: 10.94%
MSCI EAFE (International Stocks): 19.96%
MSCI Emerging Market Stocks: 27.78%
Credit Suisse Hedge Fund Index: 4.86%
Data provided by Orion
Financial Market Performance
Global stock markets continued to perform well through the third quarter of 2017. Performance in international and emerging market stocks was particularly strong, continuing the recent trend of underperformance of domestic stock indices relative to their foreign counterparts. Regardless, domestic equities performed well, with larger companies driving the overall market higher. Oil markets have recovered significantly from the February 2016 lows and the oversupply is slowly being stripped from the market. Expectations for higher oil prices are growing slowly as the market continues the protracted process of rebalancing.
Fixed income markets have also performed reasonably well. Credit markets continue to show strength as defaults, particularly in the riskier high yield universe, remain at very low levels. The yield on the ten-year treasury is slightly lower compared to the start of the year. The most significant changes in the domestic fixed income markets is that the shorter maturity segment of the yield curve has shifted higher as the Federal Reserve continues to slowly increase short term interest rates towards more historically normal levels.
THE LONG ROAD TO NORMALCY
Economic growth in the US and across the world is rising simultaneously. The rate of growth overall isn’t magnificent, but this is the first time since the global financial crisis that the major economies across the world are showing encouraging economic prospects. The Eurozone is leading the global growth pickup and this is encouraging trade across the Atlantic and with the Far East. Inflation has remained below target ranges, but economists expect inflation to normalize as unemployment across economies continue to drop and economic growth accelerates. These expectations of a slow shift higher in inflation over the next several years is driving many central banks to shift away from the aggressively easy monetary policy regimes that characterized the post financial crisis reactions of the major central banks.
These circumstances have driven the shift of monetary policy towards a more normal state. The Federal Reserve has set the short-term interest between 1.00% and 1.25%. The Fed also announced their intention to allow a portion of the Treasury and mortgage securities that were purchased during the previous bond buying campaigns to mature. Currently this amount is relatively small at $10 billion per month compared to the size of the overall balance sheet of the Federal Reserve which is approximately $4.5 trillion. This pace of $10 billion per month is expected to increase by $10 billion each quarter through next October, at which point the pace of maturities will be $50 billion per month.i The consensus by many market participants is that the process of shrinking the balance sheet is likely to be executed in a largely orderly manner, though the Federal Reserve lacks experience in this area.
The European Central Bank continues its negative interest rate policy with excess funds deposited at the ECB offering a yield of -0.40%. The ECB is still currently engaged in a bond buying program with a current monthly pace of €60 billion. This program is intended to run until the end of December 2017, but it may be extended further if necessary.ii The Bank of Japan is still positioned with a very aggressively easy monetary policy. The excess funds held at the Bank of Japan are subject to a negative interest rate of -0.10%. The Bank of Japan also maintains a substantial bond buying programs, along with a separate asset purchase program that buys Japanese Exchange Traded funds and Japanese Real Estate Investment Trusts. The Bank will conduct purchases of Japanese Government Bonds at an annual pace of about 80 trillion yen (or $708bn) – aiming to hold the 10-year Japanese Government Bond yield at zero. The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) at annual paces of about 6 trillion yen (53Bn USD) and about 90 billion yen (800mn USD), respectively.iii The size of the Bank of Japan’s balance sheet has grown significantly, recently passing that of the Federal Reserve. The Bank of England still maintains a low interest rate of only 0.25%. The Bank of England is currently maintaining £10 billion of sterling non-financial investment-grade corporate bond purchases, and £435 billion of UK government bond purchases.iv The Bank of England is much closer to balance sheet normalization than the Bank of Japan or the European Central Bank, and in this regard the Bank of England is not trailing too far behind the Federal Reserve.
The Federal Reserve is embarking on the slow and measured process of removing the excess stimulus put into place in response to the financial crisis, but the overall liquidity that has been injected into the global financial system has been staggering. Fully normalizing these assets will take a considerable amount of time and it will likely not be removed as quickly as it was injected. Meanwhile, the effects of the Japanese and European monetary policy are not restricted to their borders. Monetary policy engages in global markets, and this causes central bankers to necessarily impact foreign markets when they are only targeting their domestic markets. This provides the Federal Reserve some cover during the balance sheet reduction process, with the European and Japanese policies injecting more liquidity than the Federal Reserve is removing.
CHECKING UNDERNEATH THE BANDAGES
Removing a bandage isn’t going to fully reverse the effect of application if it actually allows the wound to heal. In the same way, the scars of the global financial crisis are not fully healed by the QE programs, but the liquidity added into the financial system did stabilize the financial system enough to make the global economy meaningfully more shock resistant. To continue the metaphor, the bandage doesn’t heal the wound itself, it simply assists in guarding against infection. The bandage had likely been left on too long, likely creating some inflammation in the global economy.
The bond buying programs utilized by central banks have been credited with a wide array of benefits, though evidence for some of these effects remains tenuous. Some of these effects are very clear and hold a much more direct relationship. The most obvious of these effects are those of providing liquidity to what was previously a system suffering from a scarcity of liquidity, and the direct effect on asset prices. The benefit of the liquidity injection into the financial system is asymmetric in the way that the additional injection during a period of scarcity is far more impactful than the removal of that additional injection during the current period defined by a broad abundance of liquidity. The effect on asset prices appears to be much more symmetric, as the funds that sought out other investments in the place of the Fed purchased Treasury Bonds and Agency Mortgages may once again be attracted back to the Treasury and Agency Mortgage markets. The incremental drop in demand for other financial assets will need to be replaced, otherwise downward price pressure will emerge.
The effects of reversing the asset growth of global central banks is not necessarily the direct opposite of the effects markets experience as these programs were introduced. This is primarily due to the conditions of the economy and markets seven years ago were significantly different than they are today. The mechanical effects of reducing the Fed’s balance sheet are likely to create some downward pressure on the valuations of risk assets, as increased supply is being introduced into the risk-free treasury market. Every asset is priced from the yield curve, and if those interest rates are pushed higher from incremental supply growth, then the valuations for riskier assets should drop in order to compensate investors appropriately for the marginal risk attributed to these riskier securities. This doesn’t necessarily mean asset prices will fall as the balance sheet normalization process begins as other factors are having a more meaningful impact on equity prices, particularly earnings growth. If earnings continue to grow, and the normalization process is executed slowly enough, the valuation may drop of many riskier assets while the price rises due to the strong earnings growth. The normalization process does introduce more risk factors as the financial markets will be more sensitive to larger budget deficits, corporate revenue and profit declines if they do occur.
The story remains the same in fixed income markets and it will continue to be a more difficult asset class to navigate over the next 12 to 24 months, but our focus remains on managing the overall risk of the fixed income segment of the portfolio allowing it to provide a degree of stability while still generating current income. The Federal Reserve still maintains a broadly dovish bias in the process of raising interest rates. This may cause the process of normalizing monetary policy to become slower than the trajectory currently advertised. The evolution of the balance sheet reduction process may also introduce periods of fragility into the marketplace as the reduction accelerates, but it currently appears to be a smaller risk.
Many equity markets may struggle to maintain lofty valuations as growth in operating profits may be difficult to capture, and high interest rates may cause investors to decrease their search for yield in the higher dividend paying sectors of the market. These changing trends are not immediate, but they will likely have strong impacts on overall performance over a multi-year period. The acceleration of economic growth has boosted revenues allowing the significant earnings growth that has underpinned this bull market to continue even further. As earnings growth continues, these higher valuations will be easier to maintain, but that places equity markets in a particularly vulnerable place in the event of a future growth slowdown. These circumstances require a disciplined risk management process that allows us to capture the returns of this bull market without recognizing any additional or unnecessary risks.