January Capital Markets Review

19 February 2018

By Geremy van Arkel, CFA®

January, by all measures, was another fantastic month for investors. All of the embedded and accepted trends remained fully entrenched: economic growth was driving forward, asset prices were rising at an accelerating clip, and investor confidence and risk taking was reaching for new heights. And, investors love more of the same, the trend is your friend. With the S&P 500® up 7% at its peak for the month, the mind of the market was unmistakably bullish. According to the Investors Intelligence survey, just 12.7% of investment advisors were bearish in January, the lowest reading recorded since 1986. Further, January capped the longest run in history where the S&P 500® had not dropped more than 5%. Of course, the offset of all of this optimism is that everyone hates bonds, which is nothing new. Unlike 2017, when high-quality fixed income assets rallied alongside equities, in January the Barclays Treasury Long Index gave up 3%. Coincidently, or expectedly, this 3% loss was precisely what our correlation estimates projected, given that the S&P 500® gained 5% for the month. However, for those that haven’t been paying attention, all this overwhelming optimism and risk seeking has come to a complete full stop in February.

As I write this, the Dow Jones Industrial Average had lost over 1,000 points on two separate days last week and was down over 10% from its peak in January. Again, we are reminded of how quickly, yet not at all surprisingly, the asset prices’ floor can give out and cause inevitable aftershocks which ripple through an entire economy. After just five days, the foundation of the high asset price thesis that was years in the making may now be called into question.

In many ways, this year seems eerily similar to 1987. In early 1987, economic growth and earnings were charging forward, asset prices were rising at an accelerated rate, and there was a healthy dose of risk taking – rightfully so. The global economy had emerged from the malaise of the 70s and had been improving for five years, interest rates had declined significantly, and in general investors felt like there was a solid foundation to support elevated asset prices. But as always, there was something to worry about. The Federal Reserve Bank (Fed) had begun to raise short-term interest rates, and the White House was embattled in the Iran-Contra scandal. But it was believed that the new tax reform was going to settle those nerves. Overall, the footing felt firm – all the way up until the October crash when the floor in asset prices collapsed.

As for this recent attack of volatility, the story that keeps making headlines is that possible inflation and rising interest rates could finally curtail the economy and impact stock prices. Yet this is in no way new news. Fears of inflation and rising interest rates have been on the forefront of investors’ minds for at least seven years. Pundits have repeatably beat the drum that interest rates would one day rise and that bonds are a risky asset. This is a foundational brick in the rational for high stock prices. You can’t rely on the safety of bonds if interest rates are going to rise, therefore you should run to the safety of stocks. This nearsighted guesswork ignores the negative impact that rising interest rates (if they rise materially) could have on economic growth and stock prices. Now, it seems that investors have put two and two together. If interest rates do rise, maybe the real risk is in high stock prices? This, of course, is the nearest and most relevant story to apply to this recent bout of selling.

We, too, have been concerned about the material increase in the Fed Funds Rate and the reversal of Quantitative Easing (QE). Over the past couple of months, we at Frontier have extensively reviewed and carefully updated our bond model to better account for the Fed’s rate increases and the impact of the reversal of QE. We have also taken steps in our asset allocation process to account for the higher short-term interest rates and the potential risks to long dated high-quality bonds. However, the actual price action in the bond market, to date, doesn’t seem to imply that fixed income investors are concerned at all about rising interest rates. The Fed has raised the Fed Fund Rate five times, and begun the reversal of QE, but the yield curve has actually flattened. Short rates, which are directly impacted by the Fed, have risen, but long-dated bond yields have largely remained the same.

The below chart shows the history of the 10-year treasury, minus the 2-year treasury spreads. The spread approaching the zero line implies that short-term bonds offer the same yield as long-dated bonds and vice versa. It is hard not to notice that the flattening of the treasury yield curve has historically proceeded recessions (the grey shading), as well as large declines in stock prices. This implies that when the Fed raises short-term interest rates, the higher interest rates do have a contractionary effect on the economy – and sooner or later, on stock prices.

Shying away from long-dated high-quality bonds is a natural response in the face of possible inflation and rising interest rates, but we must not view assets in isolation. Most investors hold a portfolio of assets; stocks for growth, fixed income for stability, and commodities to combat possible inflation. But it is stocks that are usually the largest portion of an investor’s portfolio, and it is stocks that experience the largest possible variation in pricing. In other words, while stocks provide the growth in portfolio values when growth in the economy is occurring, stocks also experience the largest declines when the growth thesis doesn’t hold up. This, then, begs the question: what should an investor own to offset a poor outcome for stocks?

Historically, prior to 2009, the S&P 500® experienced a 10% decline about every 12 months, and a 20% decline about once every 5 years. This, of course, sounds way more frequent than we have been accustomed to in the post-2009 era of extensive central bank intervention. However, when these declines inevitably occur, there are only two reliable points of safety. First of all, the simplest manner in which to curtail risk is to hold more cash or money markets. Secondly, investors can hold high-quality fixed income bonds, which offer an added yield over holding cash, and which offer potential price appreciation during times of deflation or panic. And as astute investment historians will recall, at extreme points of duress – such as 2008 – it was money market funds that broke the buck and savings accounts that were called into question due to the risk of bank failures. While we have extensively studied the relationship of stocks, bonds, commodities, and money markets during points of risk, the data below is a reminder of the power of holding high-quality fixed income bonds during recent stock market declines.

January Strategy Review

Currently, Frontier strategies are positioned about as conservatively as they have been in quite some time. Most Frontier strategies hold lower exposure to stocks than our benchmarks and increased exposure to fixed income. Frontier strategies are also broadly diversified across an array of asset classes, not just subsets of equities. We also have the added benefit of implementing our strategies using actively managed mutual funds, many of which we believe to be conservatively positioned as well. And perhaps most importantly: we have been here before. Members of the Frontier management team have managed portfolios through the turbulence of 1987, 1990, 1994, 1998, 2000-2002, and most recently, of 2008.

Overall, January was a solid month for investors and most Frontier strategies experienced above average returns. But, February is a complete pivot in capital markets action relative to what we have experienced over the last 9 years. It is difficult to tell at this time what the recent price declines in capital markets imply, or how long this asset repricing will last. As unsettling as these declines are, they are normal, if not expected. It is also worth keeping in mind that falling asset prices represent future purchasing power. Perhaps the silver lining of these storm clouds? Lower asset prices enable us to redeploy conservative capital into higher future expected return assets. For long-term investors, a little volatility is not always a bad thing.

Past performance is no guarantee of future returns. 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 in vesting consider fees and expenses.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third party sources believed to be reliable but it is not guaranteed and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Sources include the Wall Street Journal and Morningstar. All calculations by Frontier Asset Management, LLC.
Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
In reviewing any performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information.
It is generally not possible to invest directly in an index. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
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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Frontier’s performance is available on our website – www.frontierasset.com.

Monthly Perspective