Broadly diversified portfolios managed by B|O|S generated modest gains during the third quarter, following stronger gains in the first half of the year. Bonds and U.S. large company stocks led the way while smaller company stocks and foreign stocks lagged.
The U.S. economy continued to grow at a moderate pace although concerns of a recession grew as trade negotiations with China took a turn for the worse and reports on the manufacturing sector were disappointing. U.S. large company stocks, as measured by the S&P 500, gained 1.7% during the quarter while smaller company stocks declined in response to heightened recession concerns. The Russell 2000 Index of small company stocks was down 2.4% for the quarter.
Foreign stocks, as measured by the MSCI ACWI ex U.S. Index, declined 1.8% largely due to strength in the U.S. dollar. The dollar gained more than 3% against major currencies including the euro, British pound, and Chinese yuan. Emerging market stocks were hit particularly hard by the increased tensions between the U.S. and China on the trade front. The MSCI Emerging Markets Index declined 4.25% during the quarter.
Bonds generated solid returns during the third quarter as interest rates declined. The Barclays Aggregate Bond Index, a broad index of high-quality U.S. bonds, gained 2.3%. The Federal Reserve responded to recessionary concerns by reducing short-term interest rates twice during the quarter. These rate reductions marked a reversal in the Fed’s strategy – the Fed had been in a tightening cycle (raising interest rates) as recently as this past December.
During the quarter, stock investors displayed somewhat surprising equanimity in the face of two developments that had the potential to trigger major market gyrations – the attack on Saudi Arabia’s oil fields and the House Democrats’ decision to move forward with an impeachment inquiry. While there are rational reasons why investors’ reactions to these events should have been muted, we know from past experience that investors are not always rational. Perhaps the muted reaction reflects a new willingness on the part of investors to look past the headlines and focus on the longer-term economic impact, an approach we firmly endorse.
Beginning with the financial crisis in 2008 and during the 11 years since, the word “unprecedented” has been used to describe market developments so often that it may be losing its ability to focus the investing public’s attention. With stock prices on a generally upward trend, it can be tempting for some to downplay risks in the current environment. Against this backdrop, we advise remaining vigilant to the potential implications of the unprecedented market developments we continue to encounter 11 years after the deepest recession since the Great Depression.
In the current market environment, the growing prevalence of negative-yielding bonds in major countries around the world warrants careful attention. This development was inconceivable prior to the financial crisis and has accelerated since. At last count, nearly one-third ($15 trillion) of all high-quality bonds in the global marketplace were trading at negative yields. For the privilege of lending money to foreign governments including Germany, Japan, and France, investors in these countries’ bonds are earning zero interest and locking in a guaranteed loss on their principal when the bonds mature.
In the U.S., government bond yields are still positive, but the trend has been downward in this country as well. For example, the 10-year U.S. Treasury bond yield reached a low of just 1.46% during September, within 0.10% of its all-time low.
As yields have trended downward, owners of long-term bonds have benefitted. At the extreme, investors who purchased Austria’s 2.1% 100-year bond when it was issued in 2017 have nearly doubled their money in just two years.
So, why do these extraordinarily low bond yields around the world warrant concern? The most compelling reason is that these low yields are unsustainable, in our view. Since the advent of credit, savers have been compensated for deferring their consumption and borrowers have paid for access to other people’s money. For savers to be sufficiently compensated, they must receive an interest rate that exceeds the rate of inflation. This relationship has held in the past – for example, in the U.S. since 1926, the 5-year Treasury bond yield has averaged 5% while inflation in the U.S. has averaged 3%. On average, investors (savers) willing to lend to the U.S. government for five years earned a return of 2% after adjusting for inflation.
At present, all U.S. Treasury bonds with maturities of 10 years or less are yielding less than the inflation rate. As noted above, the relationship is even more extreme overseas. At some point, we expect these unsustainable yield levels to give way to higher yields that reflect a more normal relationship between lenders and borrowers.
Alas, it is impossible to know when this current low-yield environment will reverse and yields will rise. Considering the landscape, it doesn’t appear this reversal is imminent. Then again, major market reversals are unpredictable by their very nature. When the reversal occurs, long-term bonds will experience substantial losses. Moreover, rising yields could also trigger declining stock prices since low yields have helped elevate stock prices in the years since the financial crisis. For these reasons, we recommend remaining disciplined and keeping bond maturities relatively short. While the returns from shorter maturity bonds will lag the overall bond market when yields decline, as has been the case so far this year, shorter-maturity bonds will outperform when yields begin reverting to normal levels.
Written by Rich Golinski, CFA, Chief Investment Officer; [email protected]
|Index||Market||06/30/19 – 09/30/19||Year-to-Date – 09/30/19|
|Standard & Poor’s 500||Large Co. U.S. Stocks||1.7%||20.6%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||1.4%||17.8%|
|Russell 2000||Small Co. U.S. Stocks||-2.4%||14.2%|
|MSCI All-Country World ex U.S.||Foreign Stocks||-1.8%||11.6%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||0.9%||4.5%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||2.3%||8.5%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||0.3%||2.8%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||3.6%||10.0%|
Securities Markets Return Data Source: Morningstar
Key economic indicators compiled by Jeffrey Blanchard, CFA, Director of Research; [email protected]
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