I’ve good news & bad news for investors – Which do you want first?

Posted by David Nelson, CFA on September 25, 2016 in Investment Management | Leave a comment

By David Nelson, CFA

I’ve got some good news and bad news.

The good news is: stocks, bonds and gold exhibited high positive correlation last week all moving higher giving most investors something to cheer about after a rough start to the month.

The bad news is: stocks, bonds and gold exhibited high positive correlation showing the next downturn may give investors few places to hide.

Correlation Matrix SPY, TLT, GLD (September – Positive Correlation)

Correlation Matrix SPY, TLT, GLD (10 years – Negative to Flat Correlation

If yields are close to a floor which is certainly a point of debate, what happens if we lose the strong counter balance bonds  offer equity investors? Tactical is certainly an option as most tactical programs will eliminate asset classes as they move into negative trends. Gold is always a good standby and finally hedged equity can help slow down the erosion of capital.

Yes, it’s true that keeping all your money in stocks long term will beat just about every strategy out there but tell that to the investor who buys in just before a major downturn. I’ve been doing this for a little while and if there’s one thing I’ve learned it’s that “There Is No Holy Grail.” Diversifying among strategies not just asset classes can give most investors and portfolio managers the tools to weather any storm.

Since bonds have been the biggest hedge for stock portfolios for most of the last century let’s start there. While there are many periods when stocks and bonds move together, bonds provide that strong counter balance in economic downturns moving higher when stocks move lower. Bonds have been in a secular bull market since the early 80’s pausing when the economy threatened to overheat or when the Fed put a speed bump in its path.

The chart above shows the slow steady march lower in 30 year treasury yields following former Fed Chairman Paul Volcker’s “shock & awe” campaign to stamp out inflation. 30 year yields lived for a brief time above 15% before they started the long slide to where we are today. Could yields go lower? Of course they could as world central banks’ flirtation with negative rates is evidence they are willing to try almost anything to push up inflation expectations. Despite few signs of success they continue to repeat their efforts expecting a different outcome.

Insanity: doing the same thing over and over again and expecting different results. – Albert Einstein

Here in the U.S., I suspect even if the economy were stronger then recent data suggests, the Fed seems completely willing to risk a policy error. To be fair, a simple exercise can help answer the question as to whether or not the Fed should have hiked last week as it was the last real opportunity before the December meeting.

If Fed Funds were sitting at 3% and we were working off the same economic data, what would be the expected decision from the Fed? It’s doubtful a hike would even be on the table. The truth is as I’ve stated in previous posts; “the Fed missed their opportunity all the way back in late 2013 when they could have hiked into rising GDP and a raging bull market in U.S. equities.”

To appease some of the more hawkish Fed Governors, Chair Yellen has indicated she still expects rates to go up before year’s end. Probability tables only moved slightly following Wednesday’s release bumping up to a 46% chance of a hike at the December meeting.

From the market’s perspective with an election in-between December seems a lifetime away.

Despite the lack of a hike this month and the knee jerk reaction pushing 10 year yields lower and stocks higher I’m going to go out on a limb and predict we’ve seen the bottom in rates.

The thought process behind this prediction doesn’t start here but on the other side of the planet. No central bank has sung the praises of negative rates more than the Bank of Japan. The first evidence that they we’re starting to realize there are limits to this strategy was back in July when they disappointed the market keeping their target for monetary base expansion unchanged at an annualized 80 trillion yen ($774 billion).

For the first time since March, Japan 10 year gov’t bond yields spiked briefly last week into positive territory before settling modestly below. The announcement that they would move away from a rigid target for expanding the money supply was at the heart of the sell-off. They are beginning to understand how central bank policies can destroy a banking system an idea our Fed should be open to as well.

In Europe, Germany’s 10 year yield’s have made a couple of attempts to live above the zero line as well. Could it be that negative yields are not the Holy Grail central banks thought they were?

Why is this important for U.S. bond investors? One of the principal underpinnings constructing a ceiling over U.S. rates is the spread between sovereign yields and our own. Even if economic activity picks up meaningfully the long end of the curve would still be attractive to investors with sovereign debt yields in negative territory.

Despite evidence to the contrary, central banks have their limits. At some point sanity returns and the emperors find their clothes.

While the chart of above displaying 30 year yields clearly shows U.S. Bonds in a secular bull market, I think it’s safe to say that even if it isn’t over we’re a lot closer to the end then the beginning.

*At the time of this article some funds managed by David Nelson were long SPY, TLT & GLD