As Smokey Robinson might have sung:
If there’s a smile on my face, it’s only there trying to fool the public. But when it comes down to raising rates now, honey, that’s quite a different subject.*
2017 should have a smoother start than 2016. 2016 started with the S&P falling nearly 8%. U.S. small and mid-cap stocks followed the S&P 500 lower. China’s equity market slid into bear market territory. Oil prices collapsed, bottoming at $26 in February. High yield bonds began to free fall as the oil price drop exacted its vengeance on overleveraged commodity companies.
Global growth and the U.S. economic expansion came into question. Volatility was high and then the oil market bottomed in March. High yield bonds started to rally and the return to risk assets was on…until mid-year when the market became focused on Brexit. Finally after the Brexit and another brief sell-off, the markets focused on the upcoming U.S. elections.
The U.S. election shocked the pundits. Bonds traded in a wide range election night and traded lower the next day. To close the year, the Fed hiked rates 1/4 pt at the December meeting. Projections from Fed members were for three increases in 2017.
The U.S. Election
Now if I appear to be carefree, its only to camouflage my sadness.
In the spirit of Populist movements, Facebook, Instagram and Twitter, we may have just witnessed the polls and polling numbers as the new horse and buggy. An antiquated system being phased out by technology. We live in a reactionary world, and now opinions change with a Tweet. Instant gratification is demanded but, over the long term, that is not how the financial system works. The Fed always has been there for the protection of the banks. The idea is if the banking system is sound, the economy will flourish, providing for the masses.
To shield my pride I try to cover this hurt with a show of gladness.
The President-elect has been a huge critic of the Fed and their policies of low interest rates. The Fed has guided us back from the abyss since the Financial Crisis. Albeit with a zero interest rate policy (ZIRP) that has been followed by Central Banks around the world. In my opinion, The President-elect would like a less intrusive Fed in the financial system. But how will this work with the near celebrity status of the Fed Chairs? Doesn’t every little baby economist want to be the next Fed Chairman to save the world? I would think there is a lot of hand wringing going on behind the Fed’s closed doors as we enter 2017.
But don’t let my show convince you that I’ve been happy since you decided to go.
The election was a titanic shift in so many ways but there are still huge issues surrounding the size of U.S. debt. The argument here has been that debt is deflationary. We believe the new regime in all probability will expand a national debt that is at or near 20 trillion dollars.
Trumps plan for fiscal expansion is based on:
- Corporate and individual tax reform
- An infrastructure spending program
- And the repeal or reform of the Affordable Care Act (ACA)
Starting at a debt base of 20 trillion dollars the stakes are enormous. Since the election, rates on the 10-year Treasury have risen from 2.29 to a year end close of 2.46. A mere 17 basis points, but it feels like more than that. The rush to equities has been swift and relentless. But without one policy enacted, the cost of government borrowing has gone up. We believe the Fed will monitor all this and err on the cautious side, trying to stay news-relevant amid all the equity exuberance.
Well, there’re some sad things known to man but not too much sadder than the Tears of a Fed.
Bonds, Facebook and the Millennial Question
As the New Year turns to 2017, if you have read my previous missives, you know we have been in the lower for longer camp on interest rates. As active managers, we need to adjust to fiscal and monetary changes that will affect how we invest fixed income portfolios. After observing this election fought on Facebook, Instagram and Twitter, I was looking for a macro idea to capture the public’s reaction to the end of the Great Bond Bull market that began in 1981.
I came across some YouTube videos of Simon Sinek1, author of the book Start With Why, speaking about the process of millennials entering the workforce. Facebook, Instagram and Twitter provide an immediate voice for people to be heard. And along with that, instant gratification in the form of “Likes.” But the approval syndrome is addicting and intoxicating. Simon points out that Millennials grew up in this instant gratification world, so as they enter the workforce they become disenchanted when they don’t reach the Summit, not quite realizing the path to climb the mountain and to reach the apex involves time.
Bonds became the “Dislike” overnight after the November election. Since the great bond bull market began, bonds provided the instant gratification. Taking a step back for a minute, buying a bond is buying a cash flow device. That’s all it is. The duration of the portfolio is the climb. The duration is where the cash flow is. The cash flow leads you to your summit and for most of us that is retirement.
With no fiscal policy yet in place, the U.S. dollar has surged, which could affect companies’ earnings. The bond bull market had 30 plus years duration. Any stumble in policy enactment, trade wars, etc. could help bonds a bit in the New Year. The world of bonds probably changed on election night 2016. A disciplined, prudent evaluation of all your investment allocations is always advised. Going from “Like” to “Dislike” is for opinions on the internet, not for longer term investors looking to reach their summit.
Other Comments on Fixed Income
The taxable portfolios pulled back in price a bit after the election. The cash flow should get re-invested at higher rates, providing a buffer over time as we build par value. The corporate market saw plenty of liquidity and what I would observe as normal price action through the end of the year.
The municipal bond market really became unglued after the election. When the “Dislike” button was hit, mutual funds came under selling pressure. The muni market has historically struggled with the unknown — lower personal tax rates making taxable bonds more attractive, a more aggressive Fed if inflation kicks up, talk of an Infrastructure Bank, etc. — so many unknowns. There are so many individual names and cusip structures in munis that the spreads can widen out rapidly. Tax swapping of munis with losses also exacerbated some of the selling.
Generally, the December-January period is favorable for munis. We saw munis rally into the year end after hitting a low in November. The late December rally kept the seasonality trades in place but they started at wider spreads leading to a down quarter.
Perhaps the next quarter we will be talking about Ch-ch-ch-Changes, á la David Bowie. 2017 could be a year where volatility and active management present opportunity in the fixed income environment.
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