First Quarter 2018 Review and Outlook

Q1'2018 — What Happened?

2017 was by some measures the least volatile stock market year observed since the creation of what is now known as the “Volatility Index” or “VIX” launched in 1992.[i] The first quarter of 2018 gave us clear contrast to 2017 characterized by sharp upward and downward momentum, particularly in January. The S&P 500 started the year on a tear up over +7% as of January 26th, only to fall -10.1% in the next 10 trading days. After another strong upsurge in the second half of February, US stocks sold off again, ending the quarter down (S&P 500 -0.78%, DOW -2.01%) with 8 of the 11 S&P Industry sectors in the red to start 2018. REITs were by the far the worst sector down over -7%.

Apart from Europe which was down -2.15% for the quarter, foreign stocks faired better looking at Japan, China, Singapore, and most major markets in the Middle East and South America, all of which were positive.

Bonds followed a similar geographical trend with US bonds down -1.49% (as measured by the Bloomberg Barclays Aggregate Bond Index) while international bonds were up +1.94% (Bloomberg Barclays World ex-US Corp Bond index). The 10 Year US Treasury Yield, arguably the most widely observed interest rate in the world rose sharply from 2.40% as of year-end 2017, to a quarter-end rate of 2.74%.[ii] While only 0.34% in nominal or total terms, that’s a % increase of 14% from 3 months ago.

Commodities were a mixed bag. On the uptrend, cocoa, oil and gold continued their recovery from 2017 up 38%, 12%, and 2% for the quarter respectively. Unfortunately, other commodities such as copper, sugar, and coffee suffered significant losses.

What Can We Learn from This?

While there are an infinite # of items that can be deduced from looking at a quarter’s worth of stock, bond, and commodity market data, we see a few major themes worth highlighting:

• Diversification is crucial. Quarters like this show us how unpredictable the global market really is. To achieve more steady, predictable, long-term returns over time, an investor has to be exposed around the globe and across asset classes (bond, stock, commodities, real estate, etc.) with further diversification within asset classes. This last point is made clear looking at commodities where some were up big, and others took punishing losses in the quarter. It’s also clear looking at the disparity of returns in the growth vs. value sector of the US stock market. Value continued to lag substantially behind growth stocks as they have more broadly over the last decade despite the opposite being true using a century-long timespan where value stocks have outperformed.
• Higher Interest Rates Put Downward Pressure on Asset Prices. Since the banking crisis of 2008, many central banks around the world have adopted record low interest rates. This is known as ZIRP or “Zero Interest Rate Policy.” This occurs when the banks set overnight borrowing rates at 0%. One of the criticisms of ZIRP is that suppressing rates at or near 0% for almost a decade has done WONDERS for asset prices but little to help the common (wo)man. We won’t get political on the latter part, but the former has been true throughout history. Why? If returns on safe money investments such as CDs, Treasury Bonds, and Investment Grade Bonds are so low, investors are willing to pay a higher price for riskier assets that will offer higher expected returns with more volatility (think stocks, real estate, and junk bonds). As rates start to rise, owning “risk-off” assets become more attractive again and the same high prices that seemed reasonable for things like stocks become less so.
• Bonds Have Risk Too. Aside from Low Credit Quality Ones, Mainly Those with Fixed Rates and 5+ Year Maturities — When interest rates go up, bond prices go down. The opposite is also true. As noted above, the 10-year treasury yield increased by 14% from the start to end of the quarter. With that (rates going up), US bonds suffered.
• We have been in a declining interest rate environment (despite little blips here and there) since 1982 as shown by the chart on the next page. This trend appears to have reversed (we can’t be certain) at least since the current administration was elected in Nov’16.
• If we are really at the onset of a new secular (long-term) rate rising cycle, we may have to go back pretty far in our market history books to get a sense for future expected returns in stocks & bonds. That is, to the last secular rate rising cycle.

When Was the Last Secular Rate Rising Cycle? What Investments Performed Well Then?

The next page shows a chart of the 10-Year US Treasury Yield since just after Civil War through Q1’2018. As we can see, the last time we had a long-term (secular) cycle of rates going up was from the early-1960s to the early 1980s. Rates were basically in a trading range (i.e. flat) from 1945 to the late 1950s. So, what performed well last time rates started to tick up (with 10-year treasuries going up above 3%)? In the first few years of this cycle up until 1966, stocks did very well posting positive returns from 1960–1965 in 5 out of 6 years. But overall, from 1960 through 1981, stocks didn’t fare all that great generating only ~7% avg. annual returns, well below the historical norm. In fixed income, T-bills (3-month treasury bonds) returned ~6%/yr while long-term treasury bonds earned only ~3%/yr. Gold, from 1960–1981 rose 12%/yr although most of that return was earned in the second decade of the cycle 681 (1970s) vs. the 1960s.

Why is this important? T-Bills and Gold, most often viewed as unattractive investments in this 10-year bull market since 2009, were the best investments of the 4 categories (stocks, short-term bonds, gold, and long-term bonds) on a risk-adjusted basis during the interest rate rising cycle from 1960–1981.

Lesson to Be Learned? Short-term bonds with their low yields and gold with its poor returns over the last 5 years have been subpar, particularly compared to stock returns. But, if we are in the start of an interest rate increasing cycle like many bond experts suggest, these investments could be quite attractive over the next decade if a history of the 1960–1980 period repeats itself.

Conclusion

1.) We still expect to see positive long-term returns for stocks, even in a rate rising cycle, but probably at lower levels than have been customary since the interest rate declining cycle started in the early 1980s.

a. Plain English — We will continue to hold stock but at lower levels than normal if rates keep ticking up.

2.) We will continue to hold gold as an inflation hedge and as the best solution we see for providing returns that are uncorrelated to the stock market in what could be a secular interest rate rising cycle.

3.) With bonds, we will continue to heavily emphasize short-term investment grade funds in this category, despite the fact that they may lead to short-term under-performance if rates do rise more slowly than anticipated over the next 3–5 years. We will avoid exposure to long-term bonds based on how poorly they performed in the 1960–1981 period. We will also try to avoid new investment in high yield (junk) bonds as we don’t feel the credit risk (aka default risk) inherent in them is worth the slightly higher yields they provide at this point.

[i][i] http://www.macroption.com/vix-all-time-low/

[ii] https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

[iii] Chart Courtesy of — http://www.multpl.com/10-year-treasury-rate