Few places to hide in Q1 2018

As I just tweeted out, 1Q 2018 was the first quarter since 3Q 2008 where the S&P 500 and Barclays US Aggregate Bond Index both had a negative total return. This occurrence has happened only eight times over the last thirty years!

To some degree, investors have become accustomed to a heuristic of “if stocks sell off, then bonds go up”. While the flight to quality narrative does play out from time to time, it’s clearly not always true. It is also worth pointing out that there isn’t always somewhere to hide. While cash and money-market like instruments did have a positive total return in Q1, other types of “diversifiers” were also lower, as the Bloomberg Commodities Index fell 0.79% on the quarter. Many managed futures mutual funds were also a few percent lower on the quarter. Going back the last thirty years, during the time periods where stocks and bonds both fell, commodities were positive five out of eight times, while gold was positive half of the time.

From an economic perspective one can debate whether these moves have merit and whether there’s more to come, though as we know the economy is not the market. Looking at fixed income, hawks would argue that we’re in the midst of a hiking cycle from the Federal Reserve and a tight labor market and inflationary pressures at the margin will lead to more hikes than the market is pricing in. Bond bulls point to the flattening of the yield curve and fact that the long end of the curve has barely budged, meaning the Fed’s terminal rate is likely low, inflation is contained and unlikely to push substantially higher, and the economy cannot handle substantial hikes. Nevertheless, as nominal have moved up higher than break-even inflation rates, real yields in the 5y range are now at their highest level since 2010.

Within equities investors continue to wonder whether a strong economy and recent fiscal stimulus should necessarily mean stock multiples are justified well above historical averages. One bullish argument is fading as high overnight risk free rates means that the opportunity cost of holding cash is far lower than has been in the past. Indeed, the yield of a 12 month US treasury is now 25bps higher than the yield on the S&P 500. Further after a decade plus where capital was in control over labor, it is hard to ignore the obvious gains labor is having in a tighter job market. This should mean that profit margins, which are historically elevated, may be under pressure in the years to come.

More broadly, I think this quarter highlights that investor expectations need to muted. For investors with long time horizons they need to be reminded that sometimes there’s nowhere to hide in the market, and that even asset classes such as short duration investment grade corporate bonds have risk. Over the course of a normal market cycle, far larger draw-downs than these are seen. From a tactical perspective, times like these typically cause the average investor to question their holdings and ask “what should be done”. Very few investors, even professional investors, have long term success in timing the market over the short term. It is a very difficult exercise that usually results in selling low and buying high, or selling high, watching it go low, but and inability to buy during the drop. For most people, it is more important to find the proper allocation for your specific risk tolerance and time horizon rather than trying to avoid short term losses.

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