February Capital Markets Review

15 March 2018

By Geremy van Arkel, CFA®

For quite a while now, the monthly updates have largely had a repeated “No news is good news” theme. February 2018 marked an end to the trend. It was the first month since January of 2016 in which capital markets posted material losses.  This followed January, which marked the longest stretch for the S&P 500® in history without a 5% decline.  Ironically the losses in capital markets occurred when the general investment advisor sentiment was at its most positive since 1986; according to the Investors Intelligence survey, only 12% of advisors claimed to be bearish.

Market pundits gave a bevy of reasons for February’s market activity. Inflation fears, rising interest rates, equity valuations, fiscal stimulus, U.S. government bond credit quality, weak dollar, trade wars, and political theater were all viewed as potential perpetrators.  Needless to say, investors and advisors alike were caught off guard by the ferocious selling that occurred in early February, which drove the Dow Jones Industrial Average down 12%, or 3,200 points in just two weeks.

If I was Rip Van Winkle and had simply slept through the month, February would have seemed like your normal run-of-the-mill monthly decline.  I say this because the extreme downside volatility occurred early in the month, but by the end of the month the capital markets had fought their way back from serious to only moderate losses.  Unusually, though, all of the capital markets that we follow were down for the month, including those with noticeable negative correlations, such as stocks and bonds and stocks and commodities.  However, stocks were down more than bonds, and international stocks were down more than U.S. stocks, which reflects the normal risk-return relationship: the higher the perceived risk of the asset, the worse it performed.

I am a long-term investor, but I wasn’t asleep last month.  Of all the noise that occurred during the month, I believe that the single most import factor contributing to the volatility in asset prices is rising interest rates across the board. Whether the reason interest rates are going up is due to the Keynesian forces of a strong economy, the Fed raising short-term rates, fears of inflation, or Donald Trump’s tweets is almost beside the point. The fact of the matter is that they have gone up.  And rising interest rates are obviously not good for bond prices, but are usually not good for stocks or real estate either.

In February we saw clear evidence of the power of rising interest rates. Improvements in economic growth and earnings often coincides with some increase in inflation and interest rates.  Rising interest rates and inflation lead to lower bond prices, and increased earnings lead to higher stock prices, which compete for capital.  In general, bond prices have fallen this year, which in addition to the recent increase in inflation might just be a consequence of bond prices having gotten ahead of themselves over the last couple of years.  But at times like these, everyone hates bonds.

Recently, I have often heard that inflation and rising interest rates are good for stocks.  Is this simply made up, or just more justification for jumping on the stock uptrend?  In early February, we also witnessed what real volatility looks like, and it wasn’t in the bond market.  In the first week of February, the floor in stock prices absolutely collapsed. This took investors completely by surprise.  What, exactly, was the reason for this short-lived, but violent collapse?  Investors finally connected the dots: rising interest rates may not be all that good for bonds, but they could be even worse for stocks. (For more, see the February Monthly Perspective: https://frontierasset.com/january-capital-markets-review/).

Historically, when asset prices and debt levels are high, the contractionary forces of rising interest rates has had an amplified effect on the economy.  Prior to the destructive global stock market declines of 2000-2002 and 2008, the economy was booming with no end in sight, but interest rates were rising and the Fed was tightening.  In other words: if economic growth is a function of low interest rates, increased debt levels, and rising asset prices, then when interest rates rise, economic growth and asset prices can become unstable. Hopefully this time is different.

In the age of growth at all costs, you are either growing or you are dying.  Conveniently, as monetary policy has been reversed, fiscal policy is ramping up.  Along with the previously announced expansionary tax reform, Donald Trump has also declared a massive fiscal stimulus plan, in addition to recently tweeting (!) plans to tax imports on steel and aluminum.  The combination of a strong economy, the Fed raising interest rates, massive increases in government debt, and the looming threat of a trade war has clearly fueled fears of inflationary pressures and rising interest rates.  But just like in the past, the rising interest rates could negate the simulative effects of the leverage and spending in the first place.

With all this talk about inflation, it is important to note that inflation is not skyrocketing out of control. In fact, it appears to be stable, approaching 2% a year.  It just so happens that this is the Fed’s target rate for optimal inflation. Further Fed funds rate increases will likely keep this rate in check, too.   In this modern era of low growth and high asset prices, we only need to look at Europe and Japan, who have undertaken unprecedented deficit spending, to see that fiscal stimulus may have no material impact on inflation or interest rates.

As often is the case, all of this known information is likely baked into stock and bond prices.  After all, U.S. interest rates are significantly higher than those of most other First World nations.  Our 10-year Treasury note’s yield is closer to Greece’s than it is to Germany’s (see below).
After periods of heightened volatility, fears are heightened too. Not much has really changed in the last month.  Overall, the economy and earnings are still solid, although asset prices are high.  This month has shown us that inflation and interest rates matter, and that rising interest rates may not be all that good for stock prices.  Yet given the present environment, we at Frontier maintain that it would be difficult (although possible) for interest rates to rise significantly from their current level.  While there was certainly a lot of market noise during the month, I probably would have been just as well off being Rip Van Winkle.

February Strategy Review

The down month for virtually all asset classes stopped a 15-month winning streak for Frontier’s equity-dominated Globally Diversified strategies; long winning streaks also ended for the more conservative strategies.  Unusually, long-term Treasuries fell along with equities during the month, and so did not help stem the losses from equities in our strategies.  As you know, Treasury prices usually rise when stocks are falling.  For example, before the last instance, nine of the last ten times the S&P 500® fell more than 10% on a daily close basis, long-term Treasuries rose.  After the S&P 500®’s 10.1% decline from January 29 through February 8, that statistic fell to a still hefty eight of the last ten as long-term Treasuries lost 3.6%.  That was a lot less than stocks, but still about 7% worse than we would have expected.  An allocation of around 10% to long-term Treasuries (typical for all standard Frontier Globally Diversified strategies except Capital Preservation), therefore modestly hurt performance by a relative amount.  That was enough to push the strategies from Conservative through Long-term Growth to slightly worse than benchmark performance in February.  Considering our downside first focus, that was certainly disappointing, but put into proper context the losses in February were small relative to our strategies’ annual downside risk targets.

The performance of the strategies’ asset allocation mixes may fall below that of the benchmarks in the short-term (and even over a few years) since we design the asset allocation mixes for the long-term and attempt to keep risk within our strategies’ downside targets.  However, the added value from our fund selection and how we put the funds together is more consistently positive.  In February, the funds’ added value was positive across strategies, helping to keep losses smaller than they would have been if the strategies were exclusively invested in index funds, or for that matter, were overweight value stocks, which continued their dramatic underperformance in February.

Longer-term performance continues to be solid relative to benchmarks for all commonly shown performance periods back to our strategies’ inception dates.

Frontier Asset Management’s unconstrained Alternative Strategies also had a disappointing February for the same reason as noted above: long-term Treasuries did not cushion the losses in equities.  Fund performance and how we put them together did add slightly to the Alternatives’ performance which did help cushion the month’s losses.  Longer-term performance for these strategies continues to look favorable relative to the hedge fund universe and alternative strategies available in mutual fund formats.

– Gary A. Miller, CFA

Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Diversification does not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. All calculations of performance are by Frontier.
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Index Description
Barclays Capital Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
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