October 2017Ode to Bonds – Walking the Tightrope
November 17, 2017
Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.
Walking the Tightrope
: The Federal Reserve continues its path of further interest rate increases, as several officials have cited an expectation of rising core inflation. For the last 20 years, investors have been able to rely on bond positions as a significant counterbalance to stock holdings, but periods of high/rising inflation and higher yields generally lead to less diversification benefit from bonds. Though we do expect rates to remain lower for longer due to macroeconomic and demographic forces, we identify the asymmetric risks developing in core fixed income funds and high yield bond markets in Europe and the United States as potential problem areas.
October Market Recap: The S&P 500 continued to rally with a solid gain in October, led by better than expected earnings from several technology bellwethers. Continued hawkishness from the Federal Reserve caused further flattening in the US Treasury yield curve, with the 10/2 spread approaching 10-year lows. Commodities were led higher by gains across the energy complex, particularly gasoline, which saw declining inventories and worries about short-term supply due to Hurricane Nate. The US Dollar appreciated against most major currencies, and the Euro weakened following unexpected dovishness from ECB President Mario Draghi.
Throughout October, much airtime was given to the 30th anniversary of Black Monday; on October 19, 1987, the Dow dropped nearly 22%, resulting in the worst single-day market performance in modern financial history. Several financial writers have focused on the potential similarities between the current market environment and the market in 1987, leading many to believe a similar crash is imminent. Pundits use the structural selling pressure caused by the “portfolio insurance” craze in the 1980s as a template for the next liquidity-induced crisis, which they claim will be caused by herds of passive investors, trend-followers, and short-volatility strategies simultaneously heading for the exit. For several months, we have discussed the dangers to portfolio construction presented by persistently low volatility and herd behavior. Though the prospect of pounding the table on an overvalued, complacent equity market is tempting, we also attempt to not say the same things month after month. So, in the interest of keeping our readers awake, we focus on a markedly different anniversary and draw a parallel to the current market environment.
By October 1802, Ludwig van Beethoven was becoming increasingly deaf. In the depths of his suicidal despair, he penned a letter intended for his brothers. The letter, known as the Heiligenstadt Testament, outlines his depression and embarrassment over his hearing loss. The letter is worth a read, if for no other reason than to get inside the mind of one of the most famous musicians the world has ever known. In his Testament, Beethoven identifies that as a master composer, the one thing he had taken for granted above all else, his ability to hear, was now slipping from his grasp:
…Ah how could I possibly admit such an infirmity in the one sense which should have been more perfect in me than in others, a sense which I once possessed in highest perfection, a perfection such as few surely in my profession enjoy or have enjoyed…
We all know how the story ends; ultimately, Beethoven pulled himself from despair and in fact persevered, composing many masterpieces (including 7 symphonies) after the Heiligenstadt Testament. His 9th symphony, arguably his most famous work, came over 20 years later. By which time he was nearly completely deaf.
An interesting component of the human condition is our unique ability to take for granted such important things; be it running water, food, our families, or, in Beethoven’s case, the ability of the musician to hear. Financial market participants are not immune to this behavior. At Martello, we spend a lot of time thinking about which assumptions the financial community takes for granted and how those are likely to change over time. For example, in May we discussed the assumptions underpinning portfolio risk metrics like Value-at-Risk (VAR) and how those cause potential problems when the volatility landscape changes. That mindset has also meant focusing significant energy on the role of bonds in a portfolio. For over 20 years, the financial advisory community has been able to rely on bonds as a reliable hedge to equity markets while interest rates have fallen steadily since the early 1980s. So, for what amounts to the entirety of most advisors’ careers (including our own), bonds have been the Holy Grail of investments: an equity market hedge with positive carry. However, recent months have seen the Fed note signs of rising core inflation and a healthy economic environment, leading to its acceleration off the zero bound. Several ancillary signs appear to indicate fixed income risk is rising and investors should proceed with caution.
Though investors have enjoyed a mostly reliable negative stock-bond correlation for the better part of two decades, the long-term correlation between the two asset classes is volatile and regime-dependent. As the chart below shows, there have been several periods in history with strong positive correlations between equities and bonds.