“May You Live in Interesting Times”
The above phrase is an English translation of a traditional Chinese omen. While it seems like a blessing, it is actually meant ironically and foreshadows a period of disorder and trouble. The omen feels appropriate given our current era of political and economic instability. With the combination of continued trade tensions between the U.S. and China, slowing global growth, the re-emergence of hyperactive central banks and rising geopolitical uncertainty, things are a little more interesting than we would like.
Yet despite these forces of turmoil, both stock and bond markets have continued their steep ascent. Most major stock indices are up double digits for the year, and even core bonds are up a surprising 8.5% for just the first nine months of 2019. The third quarter did start to show some cracks, however, as smaller U.S. stocks and international stocks lost some ground even as large U.S. stocks and core bonds posted relatively strong performance. The standout asset class for the quarter, though, was gold, as the proliferation of negative-yielding bonds has made the case for owning gold even stronger. The table below summarizes the third-quarter and year-to-date (YTD) performance for selected indices.
“But Why Is the Rum Gone?”
The 2003 film Pirates of the Caribbean: The Curse of the Black Pearl saw a motley crew of pirates (led by Johnny Depp’s Captain Jack Sparrow) hunting for treasure, but also with a running gag about the pirates’ desperation for more rum. Investors today are thirsty for yield in a similarly desperate fashion. While the precipitous drop in interest rates so far this year has resulted in strong price appreciation for bonds, investors are now asking themselves, “But why is the yield gone?”
The yield on 10-year U.S. Treasury bonds collapsed from 2.68% at the beginning of the year down to 1.67% by the end of the third quarter. The cause of the drop is mainly due to slowing global growth and international trade. While these heightened risks have dented CEO confidence and business investment activity, U.S. consumers (accounting for 70% of the U.S. economy) have remained resilient in their outlook and spending. The Federal Reserve seemed to err more on the side of concern, cutting rates twice during the quarter. Significantly, global central banks are once again using monetary policy as a panacea for all problems. Their re-introduction of unconventional monetary policies has resulted in record levels of negative-yielding bonds, with roughly 27% of global bonds sporting negative yields by the end of the third quarter.
How Can a Bond Yield Be Negative?
Negative interest rates are a remarkable and counterintuitive concept. The only reason this concept exists is that central banks across the globe are desperately trying to stimulate their economies, and negative rates are a key part of their plan to force banks to increase their lending activity. Historically, banks that chose to hold higher levels of cash reserves would make some positive return on those reserves. However, both the European Central Bank and the Bank of Japan have set those reserve rates at negative levels. The central banks hope that charging banks to keep their money idle will incentivize them to lend the money to businesses and consumers, thus stimulating their respective economies.
Negative rates on these bank reserves are one thing, but negative-yielding bonds are a different animal altogether. In a normal environment, lenders receive interest on their loans as compensation for the default risk that they are taking on. That rate of compensation varies, of course, depending upon the perceived level of risk. A negative-yielding bond, on the other hand, is typically issued with zero percent yield and at a price above par. By the time the bond matures, the price will drop back down to par, ensuring that the investor who holds the bond to maturity will incur a loss. A numeric example would be an investor who pays $102 for a bond yielding 0% that matures at a price of $100. If that investor holds the bond to maturity, he or she will lose $2, resulting in an effectively negative yield or return.
Given the above, one may wonder who in their right mind would buy negative-yielding bonds? There are a number of non-economic or forced buyers out there, such as European banks and index funds, which must invest in government bonds for regulatory or investment policy reasons. In addition, speculative buyers may purchase these bonds to try and profit from potential price appreciation, but do not intend to hold these bonds to maturity.
Why Do Negative Bond Yields Matter?
There are potential consequences to this strange experiment with negative rates and yields. The most obvious has been the steep appreciation in the prices of risk assets (e.g., stocks, bonds, real estate, etc.) as savers have been forced to take on more risk to maintain their lifestyles. For example, the yields on bank CDs and Treasury bonds no longer meet most savers’ income needs so they are forced to seek higher-yielding returns in the stock market. This has led to a decoupling of asset prices from the underlying fundamentals and heightened valuations. Also, with the proliferation of cheap debt, corporations have become over-leveraged to the point where many companies will be vulnerable to defaults when rates eventually rise. Most importantly, however, we believe that these types of extreme policies have actually suppressed the very economic growth that central banks are trying to create. With cheap debt comes the misallocation of capital. What that means is that weak companies are able to survive much longer than they should be able to, which in turn takes away growth opportunities from stronger companies. The end result is that weak companies that should go out of business end up puttering along, thereby keeping stronger companies from flourishing as they should.
Unsurprisingly, there is no convincing evidence that setting short-term policy rates to zero or below and buying large amounts of longer-term bonds has stimulated the economies of Europe and Japan. These policies were effective short-term tools in the aftermath of the Great Recession to stabilize financial markets. However, the two long-term drivers of any country’s economic growth are productivity and the growth of its labor force. With productivity stagnant over the past decade, population growth has become even more important than in decades past. Population growth trends, however, are negative in both Japan and the developed European countries. In the U.S., structural changes within the economy and a slowing immigration trend have also combined to reduce growth potential relative to the past half-century.
There is no way to know how long traditional stock and bond markets will continue to run without any apparent regard for the fundamentals. While it seems like an obvious decision not to invest in negative-yielding debt, it is somewhat less obvious where to invest given the heightened levels of risk and the wide ranges of return scenarios with more traditional asset classes. In view of this, we have chosen to position our client portfolios away from traditional core bonds and focus instead on specialized segments of the bond market in an attempt to generate reasonable returns regardless of what happens with interest rates. We have also chosen to trade market risk for illiquidity in a portion of client portfolios as these less liquid investments are often driven by factors beyond just economic growth and interest rate movements. In interesting times such as these, the more true diversification and consistency we can incorporate into portfolios, the better we sleep at night.
Please do not hesitate to contact your Morton Capital wealth advisory team if you have any questions or would like to review your portfolio or financial plan in more detail. As always, we appreciate your continued confidence and trust.
Morton Capital Investment Team
This commentary is mailed quarterly to our clients and friends and is for information purposes only. This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.
Certain private investment opportunities discussed herein may only be available to eligible clients and can only be made after careful review and completion of applicable offering documents. Private investments are speculative and involve a high degree of risk.
The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. Q3 returns shown are from 06-28-2019 through 09-30-2019 and the year-to-date returns are from 12-31-2018 through 09-30-2019. Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MC. In addition, MC’s recommendations may differ significantly from the securities that comprise the benchmarks. Indices are unmanaged, and an investment cannot be made directly in an index.
Past performance is not indicative of future results. All investments involve risk including the loss of principal. Details on MC’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.