No man ever steps in the same river twice, for it is not the same river, and he’s not the same man[1]. I have always loved this quote, but in the past, I have not really seen the relevance of it. To me, the quote says that while you can face the same situation twice or more in life, the experience or the situation is never the same the second (or third, or fourth) time around, and the person experiencing it all is not at the same point in their life. Being slow to see life’s elegance – or torture, some would say – after 28 years in the industry, I think I am only now putting two and two together.

That life is not one thing after the other, but rather the same thing, over and over again, is something I firmly believe in – and several topics make for a constant reminder of this theory of mine. The first grind is how, in any given month or year, Frontier strategies may or may not be beating relative yet static benchmarks for one random reason or another. This, of course, should be expected. A more interesting subject for discussion though, and a topic that has bubbled up my entire career, is the ever-present fear that interest rates are just about to rise. Last month, this subject was all over the news like a political scandal.

As a quick backstory for those that may not have noticed: interest rates have fallen consistently, almost unabated, since 1980. That’s forty years! I can only speak to my career, which is about a 30-year slice of that, but during it, the fear that interest rates are just about to rise has been an omnipresent fear in the marketplace. Every once in a while, a groundswell of hype of the coming Armageddon of significant rising interest rates will (re)surface. So far, for all intents and purposes, 100% of those pontifications have been wrong. The fear of rising rates has been so strong that few investors have ever held long-term bonds, and even fewer investment companies even offer a long-term bond fund, index, or separate account. All of this has taken place during a time when long-term treasury bonds have experienced close to the same return as the venerable S&P 500^® index for the last 20 years!

So, interest rates are the river, and I am the man – or overgrown boy, as some may say. Decades ago, I was fortunate enough to be seated at a dinner table with the CEO of a large bank. In my youthful eagerness, I naturally had to ask him for a prediction for interest rates – after all, you would think that a CEO of a large bank would have an opinion on the matter. What I was too young to realize was that a) he might not have an opinion, or, more likely b) he wasn’t going to share that opinion with me. His response to my question was, “Do you know how you can spot the amateur in the room?”.  Why, of course I couldn’t, because I was the amateur in question. His answer? “It’s the one who is still trying to predict interest rates”. One of my many lessons in humility.

Over the years, I have read countless papers and books on interest rates, and it is a subject that I secretly love. At what point do you get to call yourself an expert?  Is it 10,000 hours, or is it that you have made more mistakes than others have even thought of making? Be prepared, for here is my best prediction on interest rates: wherever they are today is where they will most likely be next year.

I believe this statement has been proven more accurate than that of the permabear bond pontificators, and perhaps more importantly, it is akin to making no prediction. Yet this simple declaration is surprisingly wise because it enables one to manage portfolios in a prediction-free and, in turn, a more methodical and predictable manner.

Yet here we are again, facing the river which, as of late, is full of rapids. Interest rates respond positively to a strong stock market; that is how they work. And, the stock market is up, way up. Therefore, interest rates are rising, for now, and pundits are predictably vocal after the fact. Second, interest rates were inordinately low due to the fears of 2020, thus some reflation should be expected. In my book, this is all very normal.

But I am no longer the same overgrown boy. I am now fully aware that interest rates can rise, they can stay the same, or they can fall – although it does seem that interest rates can only fall so far from here, as the zero line seems like a mushy floor. In years prior, I would have staunchly stood on the foundations of low interest rates, proclaimed the deflationary pressure of globalization and technology, and announced tendency of the aging first world population to slow economies down and to drive demand for savings. I would have spoken of globally coordinated easy central banks and wide interest rate differentials being a magnetic force to the lowest interest rate. Finally, and maybe most importantly low interest rates are the structural pillar of our debt-based culture. In my mind, I can’t visualize an outcome where interest rates rise materially without asset price destruction, which of course, would then, in turn, drive interest rates back down.

All of these factors are logical rationales of why interest rates are low and are also likely to remain secularly low, despite ever-present short-term upward blips. But having just witnessed the randomness of 2020, I am willing to admit that stranger things can happen. I guess sooner or later, the river might turn and about-face.

The Bigger Problem: Rising Interest Rates Leading to Risk Asset Price Declines and Recessions?

During their 40-year decline, interest rates have had several short-term bouts with inflation. Some increases in interest rates have been material. A situation resembling that of today was the interest rate increase which occurred during the late 1990s and early 2000s. This is relevant to look at because, as I stated in my last article, the other river we are now peering into is the one of similarities between the late 1990s and today.  More specifically, from mid-1998 to the summer of 2000, when the interest rates on the 10-year Treasury rose almost 2% during a stock frenzy. Following this rise, the NASDAQ proceeded to drop over 70% from its euphoric peak. At the end of that rout, the 10-year treasury bond rate settled far lower, at 3.5%.

The second case of interest rates rising materially in our recent past was the period of time following the tech wreck when the 10-year Treasury rose almost 2% – from about 3.5% to over 5% – during 2003-2006. This slow rise in the face of a real estate boondoggle contributed to the coming bust leading into the credit crisis. Thus, during the worst decade in modern history for stocks, there were two campaigns of rising interest rates. Each of these periods of rising interest rates were quickly corrected by recessions, falling risk asset prices, and, of course, corresponding falling interest rates.  At the end of that route, the 10-year treasury bond rate approached 1.5%. Again, rising interest rates facing forces that ultimately led to even lower interest rates.

That being said, if the mantra is, “interest rates are just about to rise,” where is the risk? Is the risk in the self-correcting bond prices – which, sooner or later, respond to either the higher yield or the future falling interest rates – or in stocks, which have far greater price amplitude?

Can we reroute this river permanently? That would seem like a big ask. The last and most material time period to anchor to, for that example, would be the 1970s, which weren’t so hot for stocks either. Today, with the foundational pillar of debt underlying our economy, the implications could be severe. Not to fear, though: while the media sells big, fanatical fears, the worst-case scenario rarely happens.

Therefore, as I peer into the same river again, I am not worried. Instead, I am going to stick with my best estimate that interest rates are about to stay right where they are. Rather than being a prediction, it is a release from having to make one. After all, most who have entered the game of prophecy have lost and providing reliable and consistent outcomes for investors is not a guessing game.

Capital Markets Overview

Clifford Stanton, CFA^® | Director of Investments

Investor enthusiasm could hardly be contained last month. February witnessed the largest week of global equity inflows ever – an all-time high in investors taking “higher-than-normal” risk, according to BofA’s February 2021 Global Fund Manager Survey[2] – and the Put/Call ratio succumbing to intense gravitational pull. Nasdaq OTC trading volume, too, climbed further into the stratosphere. After all, why wouldn’t investors fall for companies that don’t meet listing requirements? BBC News reported that Cambridge University researchers estimated in 2021 that Bitcoin mining is now using as much electricity annually as entire countries such as Argentina and Norway[3]. And small cap breadth reached the highest level in at least 25 years.

The rotation away from last year’s winners into more cyclically and/or Covid-exposed companies continued, with small value stocks printing a return of over 9% while large growth stocks were flat. Value and size paid off overseas as well, with international value and international small value posting S&P 500 beating returns of about 4.8% and 4.4%, respectively. And with Brent Crude surging by 18%, energy stocks advanced by over 22%, regaining some dignity after Tesla’s market cap at one point surpassed the value of the entire S&P 500 Energy sector (incidentally, Tesla was down 15% for the month).

Earnings season mostly wrapped up, with 77% of S&P companies beating on earnings and 75% beating on revenues. Even so, 4Q earnings for the S&P were down from the prior quarter, whether measured on operating or GAAP earnings. Going forward, the bar keeps moving higher; global earnings revisions set a record high recently, which could be difficult to sustain.

While equity investors continued to binge, bond investors honed their duck-and-cover repertoire. The 10-year yield increased by 33 bps from 1.11% to 1.44%, long-term Treasuries sank by slightly less than 5.6%, and investment grade bonds lost approximately 1.4%. Corporates, TIPs, Munis, and Emerging Market Debt all posted losses, while High Yield and Bank Loans generated gains of around 0.4% and 0.7%, respectively. Fixed income will likely continue to be challenged in the near term by the inflationary forces that have been growing.

Commodities ramped up their recent performance, with a gain of a little less than 6.5%. In sum, oil was the big winner, but tin, copper, and other industrial metals all did well – in fact, of the 25 commodity sub-sectors, only wheat, silver, and gold were down for the month. It seems like the long winter for commodities may finally be coming to an end.

Strategy Overview

During the month, our strategies slightly increased their target allocations to U.S. small caps and international large cap equities by reducing allocations to long-term Treasuries, TIPs, and T-Bills. Relative to our long-term allocations, we are generally underweight REITs, commodities, and absolute return. We are overweight to Long-term Treasuries, TIPs, and managed futures and specific to our more conservative strategies, we are also overweight T-Bills. Our positioning on equities has continued to transition and is now in a neutral position, with a preference for U.S. small caps and emerging markets.

Turning to performance, our small cap positioning continued to be beneficial, as that was the number one risk asset for the month. Further, our underweight to international large caps added to relative performance. However, our underweight to commodities and overweights to Treasuries, TIPs, managed futures, and emerging markets all negatively impacted returns relative to benchmarks.

With risk assets once again performing well and pushing valuations higher, our long-term return expectations for commodities and equities continued to decline. Notably, our expectation for U.S. large cap stocks hit its lowest point in 20 years. Conversely, the outlooks for all the fixed income categories that we model improved as rates kept climbing. As we have pointed out numerous times of late, fixed income in general and long-term Treasuries specifically are unattractive assets from a return perspective. Yet, they are necessary to achieve the expected risk reduction required to preserve our downside targets. Despite the euphoria across markets, now is not the time to abandon risk management. Frontier remains your risk-first partner.

[1] Heraclitus

[2] Galouchko, Ksenia. “BofA Clients with $614 Billion Hike Risk-Taking to New Records” Bloomberg, February 16, 2021. https://www.bloomberg.com/news/articles/2021-02-16/bofa-clients-with-614-billion-hike-risk-taking-to-new-records

[3] Criddle, Cristina. “Bitcoin consumes ‘more electricity than Argentina’“ BBC News, February 10, 2021. https://www.bbc.com/news/technology-56012952.