Cautiously Optimistic

Money managers are supposed to be cautiously optimistic over time. If we’re not optimistic, we risk becoming “perma-bears” – investors who don’t invest in the market because they’re always fearful. On the other hand, if we’re not cautious, at some point in the economic cycle we will wish that we had been a perma-bear.

In reality, cautious optimism is likely the appropriate state of mind 80% of the time since the market historically goes up three out of every four years. And, 10% of the time, when the economy and markets appear to be in dire straits and the majority of investors are scared, we need to be aggressively optimistic. The remaining 10%, when there is far too much optimism in the market, we need to embrace the cautious component of cautiously optimistic. Warren Buffet summarized it best: investors should “buy when others are fearful and sell when others are greedy.”

So, where are we now? Since the market bottomed on March 9, 2009, stocks have increased by almost 380%. The only bull market that had a greater run was the technology bubble in the late 1990s. That’s a scary comparison, but not one that’s altogether fair. The current rally started after a deep recession that lowered stock prices by more than 50%, giving stocks plenty of room to run. At this point, it feels as if we are on the border between cautiously optimistic and cautious. With that in mind, let’s examine how the markets are performing.

BOND MARKET

The Barclays Intermediate Bond Index increased by approximately 3% for the year, a fair return in what continues to be a low-interest-rate environment. Bond returns are a combination of interest income and price changes. Bond coupon rates remain low and prices haven’t changed much in 2017. Of course, we all want to know when interest rates will increase. That is why credit markets pay close attention to the actions of the Federal Reserve (Fed).

Currently, the Fed is making progress in its rate tightening cycle, having raised rates three times in 2017. The market is predicting the Fed will increase rates two to three times in 2018. Most analysts agree that the Fed would like to raise rates at a faster pace.

However, it appears the Fed doesn’t want to raise rates too quickly and risk slowing down economic growth that has been trending, until recently, at a pace of only 2 to 2.5% per year.

The Fed is also very sensitive to the fact that most major countries aren’t raising their interest rates. Each time the Fed raises rates and other countries don’t, the dollar strengthens, which hurts the competitiveness of U.S. company exports (since a strengthening dollar increases the price of U.S. products sold overseas). As a result, we believe the willingness of foreign countries to raise their rates will influence how aggressively the Fed raises our rates over time.

Given our forecast for below-average interest rates over the near term, we expect bonds will continue to generate below-average returns over the next several years. While our outlook for below-average bond returns over the near term is disappointing, the only way bond returns can get back to their historical 4 to 6% annualized returns is for interest rates to increase over time. Although painful in the short term, we should view increasing rates as a necessary step toward a normalized interest rate environment.

Interestingly, when the Fed raises rates, they only directly impact the short end of the yield curve. As the Fed increased rates over the last year, the two-year Treasury yield increased from as low as 1.1% to 1.8%.

Longer-term yields tend to reflect investor outlook for future economic growth and inflation. Despite the fact that the Fed raised short-term rates, the 10-year Treasury yield actually decreased last year, from as high as 2.6% to as low as 2.0%.

The fact that we saw short-term rates rising and longer-term rates declining explains why we have seen a flattening of the yield curve. One measure of the steepness of the yield curve is the difference between the 10-year and two-year Treasury yields (i.e. the 10-2 spread).

When the 10-2 spread tightens, it signals the economy may be softening. At the end of November 2017, the 10-2 spread was approximately .70% (70 basis points) with the 10-year Treasury yielding 2.4% and the two-year Treasury yielding 1.7%.

As you can see from the chart below, historically, anytime the 10-2 spread has gone negative by more than 10 basis points (i.e. inverted yield curve), the U.S. economy has entered a recession 12 to 18 months later (the grey area on the chart reflects historical recessions).