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An inverted yield curve — which describes a relatively infrequent occurrence when short-term yields are higher than long-term yields — is commonly accepted as a predictor of recessions. This recently happened when yields for intermediate-maturity U.S. Treasuries fell below yields for short-maturity U.S. Treasuries.
Q: What is the yield curve?
The yield curve represents how much it costs the government to borrow money by issuing debt across different time horizons. In the United States, this ranges from one-month Treasury bills to 30-year bonds. The interest rate on these securities generally increases with their time to maturity, which makes the yield curve positively sloping in most environments. This makes intuitive sense: Creditors and investors usually demand more return for lending money or buying bonds with longer horizons. The premium is compensation for the uncertainty associated with forecasting economic variables like growth and inflation, and that uncertainty increases for longer-maturity bonds. Yields across the curve represent expectations of Federal Reserve monetary policy. Think of 2-year yield as a proxy for the market’s expectations of what the Fed will do over the short term, the 5-year yield as a proxy of where interest rates will be when the Fed reaches the end of their current hiking cycle, and the 10-year yield as a proxy for factors that determine how interest rates behave through the cycle.
Yield curves aren’t just about fixed-income
“Equity valuations are discounted by a combination of long-term bond yields and a premium for the uncertainty of investing in stocks compared to U.S. Treasury bonds. Given the importance of bond yields to equity valuation, equity investors are affected by potential changes in bond yields just as much as fixed-income investors.” – Colin Moore, Global Chief Investment Officer, The Inflation Pendulum
Q: What’s driving the shape of the yield curve?
The premium for longer term bonds has been declining since the early 1980s. Between 2010 and 2018, the premium on 10-year Treasury bonds declined from about +250 basis points (2.5%) to -50 basis points (-0.50%),1 reflecting a combination of lower potential economic growth (driven by an aging population and a slowdown in productivity), lower inflation and an increase in global demand for government-related fixed-income assets.
At the moment, the shape of the yield curve is largely driven by actions the Federal Reserve is taking to return to a more normal monetary policy environment by raising interest rates. The Fed has raised interest rates 2% since December 2015 and has started to reduce the size of its balance sheet (unwinding the quantitative easing programs they put in place after the 2008 financial crisis). The cumulative effect of this policy change has increased yields across the curve, but the shift has been led by shorter-term bonds. Yields on two-year bonds rose from about 1% at the end of 2015 to a high of 3% this year, while 10-year yields rose from 2.25% to 3.25% over the same period. The difference between 2-and 10-year yields is currently less than 0.15% (15 basis points), down from 1.25% (125 basis points) at the time of the first Fed hike in 2015.1 The longer end of the yield curve has largely remained anchored, while rates at the shorter end of the yield curve have been pushed higher by the Fed. This has flattened the curve.
Q: What is the relationship between the yield curve and a recession?
An inverted yield curve (one where short-term rates are higher than long-term rates) is uncommon and widely accepted as a predictor of recessions. The yield curve has inverted ahead of every recession since World War II. The current environment falls into the category of being an expansion lasting more than three years, which based on historical results puts the probability of a recession over the next 24 months at about 45%.2
Recently, the yield on two-year bonds was higher than 10-year bonds, and this specific type of inversion has preceded recessions by anywhere from 10 to 30 months. Risk-sensitive assets — including both U.S. equities and credit-sensitive bonds — have exhibited a broad range of returns following a yield curve inversion between 2- and 10-year bonds.3 So, while the yield curve may predict a recession, it’s a poor stand-alone metric for structuring an investment portfolio.
Q: What’s different this time?
As Global Chief Investment Officer Colin Moore said in a recent video, there is one big difference this time: This is the first time the Federal Reserve is returning to normal monetary policy after such extraordinary measures following the 2008 financial crisis. Three things make the current experience different from those in the past:
There is no precedent for unwinding quantitative easing: The purchase of government securities by the Fed and other developed-market central banks to restore the economy after the 2008 financial crisis was an unprecedented display of monetary policy intervention. It may have reduced the responsiveness of long-term rates to changes in shorter term rates. On the other hand, the reduction of the Fed’s balance sheet that began last year could reduce demand for government-related bonds and put upward pressure on long-term yields
A very low starting point for yields: The Fed is raising rates from zero and 10-year nominal yields are close to 30-year lows due to structural anchors, which has potentially accelerated the pace of recent curve flattening.
Fiscal stimulus late in an economic cycle: Fiscal stimulus in the form of tax cuts that were approved earlier this year has increased budget deficits and the supply of Treasury debt, which could potentially increase yields across the curve.
Q: What do you think is going to happen?
We expect structural factors to continue to dominate long-term yields. And we believe that this increases the risk that the curve will remain flat and invert over the next 6-12 months. We expect the pace of interest-rate increases to decelerate sharply in 2019. We think this leaves U.S. Treasury bonds in the 2-to 5-year segment of the curve as attractive hedges against risk, and this could mean the possibility for growth and inflation expectations to go even lower in 2019. We anticipate U.S. economic growth to slow down in 2019, driven by fading effects of fiscal stimulus and monetary policy. Global trade discussions have become an increasing risk to growth as well.
A flat-to-inverted yield curve is an important signal that the regime for risk assets may be changing, and investors’ expectations for investment returns should be adjusted to reflect a slowdown in economic growth. Investors shouldn’t interpret this as a signal to sell their investments; instead, stay invested using an active, flexible strategy that adjusts your portfolio to navigate the changing risk and return landscape. For active managers who can navigate the yield curve, inverted yield curves present good opportunities to invest in high-quality bonds at more attractive valuations, while adding interest rate risk to act as a ballast or shock absorber in the event of a more sustained economic slowdown or recession.
Past performance does not guarantee future results. All investing involves risk, including the risk of loss. All references to bond yields are sourced from Columbia Threadneedle Investments as of 12/07/18.
1 Source Columbia Threadneedle Investments as of 12/07/18.
2 Source: Lawrence Summers, What you should know about the next recession published 05/16.
3 December 2018. Source Columbia Threadneedle Investments.
After 40 years of being an important part of the European Union, the U.K. voted to leave the EU in a decision commonly known as Brexit in June 2016. In a letter to the president of the European Commission, British Prime Minister Theresa May began the proceedings for Britain’s departure by invoking Article 50 (a section in the European Union agreement that allows member countries to voluntarily leave).
“…the people of the United Kingdom voted to leave the European Union. As I have said before, that decision was no rejection of the values we share as fellow Europeans. Nor was it an attempt to do harm to the European Union or any of the remaining member states … We are leaving the European Union, but we are not leaving Europe — and we want to remain committed partners and allies to our friends across the continent.”
Negotiations have been underway in the more than two years since the announcement. And with the exit date set for March 29, 2019, there continues to be uncertainty about the final outcome. Questions have come up about the outlook for Britain’s economy, as well as the outlook of the wider European continent. People are unsure about the future of the European Union, and there are still several potential outcomes, including the possibility that the separation does not occur at all.
Examining the range of potential outcomes
While the invocation of Article 50 was a straightforward process, the aftermath has been anything but. The U.K. and EU have negotiated a withdrawal treaty that outlines the terms of their future relationship, but it has yet to be approved by British Parliament. The current issues are detailed below:
The U.K.’s membership in the EU ends March 29, 2019: The United Kingdom will cease being a member of the European Union after March 29, 2019 unless it submits an application to extend or revoke Article 50. According to a landmark European Court of Justice decision, Britain is free to revoke its decision to leave the EU without the unanimous consent of other EU member states.
There’s a transition period until December 31, 2020: If the U.K. signs a withdrawal treaty — ratified by EU member countries — and passes what has been termed a meaningful vote in the House of Commons, the U.K. will enter a transition period that’s anticipated to last until December 31, 2020. During this transition period, the U.K. will have the same regulatory and treaty relationship to the EU as it does today, but it will no longer have a voice in the decisions the EU makes (such as decisions in the European Parliament, European Commission or regulatory agencies). The transition period will be used to negotiate the future relationship between the U.K. and EU.
There are multiple options if a withdrawal treaty isn’t approved: If the British parliament doesn’t approve the treaty, there will likely be three main paths open to the government:
Exit the EU without a transition period
Apply to withdraw the decision to leave the EU
Hold a “People’s Vote” or second referendum in very short order and seek to apply the outcome
Political leadership is uncertain: British Prime Minister Theresa May’s position as leader of the country and the Conservative Party has been a source of uncertainty. There was recently a vote to replace her as prime minister, but she was victorious and remains in her position. Under party rules, this can’t be challenged again for a year.
Interim elections could affect the likelihood of a withdrawal treaty approval: Holding a general election doesn’t change the Brexit options. But it may change the electoral balance in the House of Commons, and this would influence the country’s decisions to accept or not accept the Withdrawal Treaty.
Elections after the Brexit deadline would affect the negotiating period: Holding a general election after March 29, 2019 could change the form of Brexit that’s negotiated during the transition period, which concludes at the end of 2020.
Regardless of which political party or leader has control, they would likely face the same roadblocks and challenges as British Prime Minister Theresa May in drawing up a final proposal and navigating the negotiation period.
How an abrupt exit would impact economic growth and stocks
The immediate focus is whether the U.K. will begin a transition agreement on March 29, 2019 or if it will do what is being referred to as “crashing out” or exiting the EU without a transition agreement. While there appears to be broad consensus across the Houses of Parliament that they want to avoid this path, the question is: How significantly would it hurt financial markets? The International Monetary Fund (IMF) says this scenario could cost the U.K. almost 4% of GDP by 2030. With the United Kingdom ranking among the EU’s three largest trading partners and accounting for 13% of trade in goods and services, the IMF also predicts that it would inflict economic damage on the EU, causing growth across the trading members to be 1.5% lower over the same period.
Some manufacturers like BMW have said they could be forced to close their U.K. operations if Brexit makes trading more difficult. Many larger U.K. stocks may be better sheltered from a no deal than their smaller competitors because they generate more of their earnings globally, outside the EU. Domestically focused U.K. shares, which have underperformed since the initial Brexit vote, are expected to be harder hit. Investors should expect U.K. stock markets to remain volatile.
Across Europe, we expect the effect on economic growth to negatively affect corporate profits. In the day following the U.K. referendum vote, European stock markets were hit hard, and the Pan-European STOXX 600 Index went down around 7% — partly because of fears that other EU countries could follow the U.K. out of Europe. But not all sectors and companies would be equally affected, and most market analysts believe that the negative impact on European stock markets will be less than that for U.K. equities.
Assessing the risk
While the prevailing view is that the U.K.’s departure from the EU will be negative for the economy in the long run, we could be missing the bigger picture with this fixation on Brexit. With the inversion of Treasury yield curves, increasing levels of government debt and continued geopolitical risks in the rest of the world, there are still a range of risks for investors to navigate while constructing suitable portfolios. Specifically, investors in European stocks should be aware of other risks, including increasing government debt in Italy, the impact of trade discussions from the U.S. and the impending end to quantitative easing from the European Central Bank. Brexit is an important consideration for investors with international portfolios, but arguably it’s reinforcing what should be an ongoing approach: Invest with managers who are able to evaluate the risk and return profile of individual investments and who have expertise in the regions they’re investing in.
Brexit has led to increased uncertainty around the outlook for Britain’s economy, as well as the outlook of the wider European continent and the future of the European Union. There are still several potential outcomes, including the possibility that the separation doesn’t occur at all. Active managers who have done scenario planning can help weather the range of potential outcomes. Now that you understand some of the details directly from one of our U.K.-based investment professionals, it’s time to join the conversation as the events unfold.
The STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region. The FTSE 100 Index is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization. It is not possible to invest directly in an index.
The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.
Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies.
Recently, disappointing returns in the floating-rate loan sector have caused investors to question its prospects in 2019. The flow of money out of the asset class has been abrupt, and this pressure caused loan prices to decline almost 2% since late October.1
Q: Why are the outflows occurring?
As the name suggests, floating-rate loans don’t make a fixed-interest payment, or coupon, each period. Instead, their coupons reset every 30, 60 or 90 days, floating up or down with the changes in prevailing short-term interest rates. This floating feature makes loan prices less sensitive to shifts in interest rates, so there tends to be a significant uptick in flows when the Federal Reserve is actively raising rates, and the trend reverses when rates or rate expectations stop rising (or decline).
An equally important consideration that’s sometimes overlooked is the financial health of floating rate issuers. Our research team sees underlying credit fundamentals as sound, and we don’t expect defaults to increase in a significant way from historically low levels of 1%-2%. But the sector is not immune to macro or geopolitical concerns about potential slower economic growth, trade and tariffs, China’s growth and Brexit. There are also expectations that the Federal Reserve policy will pause or reach a conclusion to interest rate increases by early or mid-2019, and investors have responded by retreating from the floating-rate loan market.
Q: Will outflows affect the floating-rate loan market?
We acknowledge the asset class may face continued selling pressure in the short-term. Like everyone else, we’re watching activity in some of the bigger benchmark-tracking floating-rate loan ETFs very closely because flows in and out of those products tend to be a leading indicator of activity and future floating-rate loan prices.
On the positive side, market liquidity remains reasonably solid with active buyers. This appears to be fueled by continued demand from the largest component of the loan market, collateralized-loan obligations (CLOs). The strong CLO pipeline helps diversify the investor base to include institutional managers and potentially mitigates the risk of sizable outflows from retail investors. Our floating-rate loan group is a large issuer and manager of CLOs, and we continue to be active in the market.
Q: How will a slowdown in interest-rate increases affect floating-rate loans?
The appeal of floating-rate loans usually peaks when interest rates are rising, but they could help diversify your portfolio in any environment. When rates are rising, the median annual return for floating-rate loans, as gauged by the Credit Suisse Leveraged Loan index, is more than 6% higher than for U.S. Treasuries and the Bloomberg Barclays U.S. Aggregate Bond Index. But what’s possibly overlooked is that floating-rate loans have also delivered attractive absolute and relative performance regardless of the broader interest-rate environment. Because yield is such a significant component of total return, floating-rate loans also have outperformed U.S. Treasuries and the Bloomberg Barclays Aggregate Bond Index when rates are flat. It’s only when rates fall that we’ve seen floating-rate loans become a relative underperformer — although we still see positive returns.
We acknowledge the asset class may face continued pressure in the short-term. And we respect the need to provide liquidity for investors who may want to reduce exposure. We believe it’s warranted to maintain a defensive position in floating-rate loan portfolios and hold higher cash balances. In times like this, experience has taught us to be proactive about liquidity, to favor higher quality securities and to reduce focus on higher risk segments such as CCC-rated loans and second-lien loans (which have a subordinated claim on assets in the case of a default).
Past performance is not a guarantee of future results.
Floating rate loans typically present greater risk than other fixed-income investments as they are generally subject to legal or contractual resale restrictions, may trade less frequently and experience value impairments during liquidation.
The Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index that tracks the daily price, coupon, pay-downs and total return performance of fixed-rate, publicly placed, dollar-denominated and non- convertible investment-grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity. The Credit Suisse Leveraged Loan Index tracks the investable market of the U.S.-dollar- denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or a1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries. Indices shown are unmanaged and do not reflect the impact of fees. It is not possible to invest directly in an index.
Deficit concerns: U.S. tax reform boosted economic growth but also increased the budget deficit.
The twin deficit hypothesis: This suggests that a growing government budget deficit and a widening trade (current account1) deficit go hand-in-hand. The government’s increased deficit stimulates the economy and revs up consumer spending, which reduces the national savings rate and causes the U.S. to borrow more from abroad.
There are more risks in high-yield bonds compared with traditional fixed income. The asset class has navigated three significant default cycles over the past 30+ years. In each cycle, there was a meaningful decrease in high-yield bond prices, but they recovered alongside the economy, which proves the durability of the asset class to investors. High-yield bonds have demonstrated risk and return characteristics that fit between traditional fixed income and equities, and they can offer investors attractive risk-adjusted returns across the economic cycle.
2. Rising interest rates aren’t necessarily bad for high-yield bonds.
Typically, interest rates rise in response to increased economic activity. This economic growth helps companies improve their financial health, which bodes well for high-yield bonds. Additionally, the excess spread (a measure of incremental yield over less-risky bonds) and moderate duration (a measure of interest-rate sensitivity) of the asset class act as a cushion against gradually rising interest rates. Generally speaking, a rising rate environment, short of a dramatic spike, can be good for high-yield bonds.
3. Energy is the largest high-yield sector, and it has three distinct subsectors.
Energy represents about 16% of the high-yield market.1 In 2014, the price of oil was over $100 a barrel, and the energy sector peaked. Oil prices became weaker throughout 2015, and then they dropped to under $30 a barrel by early 2016. Prices stabilized later in that same year, but not before 47 of the 175 high-yield energy bond issuers went bankrupt.2 It was the worst period for the energy sector since the 80s, and it reinforced the importance of investing in companies that can survive a cyclical downturn in commodity prices.
There are three separate and distinct energy subsectors: energy services, exploration and production (E&P) and pipelines, and each one has different characteristics and risks. Energy services is considered the riskiest subsector — it’s very competitive with low barriers to entry and low profit margins. It includes offshore drillers, who depend on higher oil prices due to the higher cost nature of their business model. E&P companies are sensitive to commodity prices, but they can hedge their production, and they typically have high asset coverage due to their reserves in the ground. Pipeline companies are considered the least risky of the energy subsectors because of the fee-for-service structure in their business models, including regulated interstate pipelines — and they tend to have less commodity price exposure. Because there’s a range of commodity price sensitivity of the underlying business models within the sector, a high-yield portfolio’s energy risk depends on its mix of subsectors.
4. Tariffs have a limited effect on high-yield issuers.
While tariffs could affect certain sectors in the high-yield bond market more than others, the asset class is generally a U.S.-centric one. U.S.-centric business models will be less exposed to the direct economic impacts of tariffs compared with global business models and likely benefit from the recent tax reforms in the U.S. We think there could be more significant risks if financial conditions and monetary policy become more restrictive or if business and consumer sentiment deteriorates.
While high-yield bonds are riskier than other forms of fixed income, they’ve proven to be a durable asset class across the economic cycle. They can offer investors attractive risk-adjusted returns, even in a rising interest-rate environment.
1Source: Energy as a percentage of the high-yield market is measured by the ICE BofAML US HY Cash Pay Constrained Index as of 09/30/18.
2 Source: Brian Lavin, Columbia Threadneedle Investments.
Investing involves risk including the risk of loss of principal. Non-investment-grade (high-yield or junk) securities present greater price volatility and more risk to principal and income than higher rated securities. Commodity investments may be affected by the overall market and industry- and commodity-specific factors, and may be more volatile and less liquid than other investments.
Passive products that track traditional municipal bond benchmarks may give investors excessive exposure to duration (interest-rate) risk, because of the way traditional indices are constructed.
Problem: Traditional indices have a quality bias
Municipal bonds have long been viewed as high-quality assets, partly because the majority of them historically carried a AAA rating. Until 2008, monoline insurance was prevalent, enhanced the credit rating of a bond and provided additional protection to investors in the case of default. However, the 2008 financial crisis caused insurers to lose their coveted AAA ratings and resulted in municipal bonds trading based not on the insurance, but on their underlying creditworthiness. Nearly 70% of the municipal market was rated AAA prior to the financial crisis. Less than 20% is today.1
Even with this change, the majority of the muni market is still rated investment grade, and many municipal indices have been designed to focus exclusively on these higher quality bonds.
Opportunity: Lower quality sectors may enhance yield with lower interest rate sensitivity
The ratings recalibration ultimately created a tremendous opportunity for municipal investors. The market now differentiates among issuers based on fundamentals and applies a risk premium reflective of their sector, creditworthiness and idiosyncratic factors. This results in investors earning more yield than when the bonds were insured and rated AAA. This yield advantage also helps buffer interest-rate volatility.
We use a metric called empirical duration to more accurately measure a bond’s sensitivity to changes in interest rates. Investors often focus on effective duration — a theoretical measure of interest-rate sensitivity based primarily on the maturity of the bond. But empirical duration uses real historical price changes to show the true sensitivity of a bond to changes in interest rates. As a general rule, true interest rate sensitivity tends to fall — and the gap between effective and empirical duration increases — as you move down the credit quality spectrum. As lower rated investment-grade and high-yield municipal bonds generally have lower empirical durations relative to their higher quality counterparts, investors are taking on less interest-rate risk when allocating to these sectors. Credit risk may matter more. Because interest-rate risk and credit risk are relatively uncorrelated, introducing the latter into an otherwise high-quality portfolio can provide important diversification benefits.
Tracking a traditional municipal bond benchmark may leave investors overexposed to higher quality bonds and, consequently, subject to excess interest-rate risk. A strategic municipal bond approach, with a focus on diversification and the flexibility to navigate interest-rate risk and credit risk, may help address this challenge.
Diversification does not assure a profit or protect against loss.
There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer term securities. Municipal securities may be affected by tax, legislative, regulatory, demographic or political changes, as well as changes impacting a state’s financial, economic or other conditions.
General obligation (GO) bonds versus revenue bonds: GO bonds are backed by the full faith and credit of the issuing municipality, and they can use all available resources to repay the debt, including raising taxes. Revenue bonds repay bondholders using revenue generated from specific projects.
Revenue bonds could be a missed opportunity. Several high-profile municipalities have recovered from bankruptcy by making cuts to bondholders. Despite this, investors’ persistent demand for GOs keeps their yields down. Revenue bonds represent over 65% of the municipal market and often trade at a lower price and higher yield than GO bonds. This gives investors who can research the details of each bond an opportunity to earn more income and improve risk-adjusted returns — particularly in the housing, hospital and other higher yielding revenue sectors.
The Bloomberg Barclays Municipal Bond Index is an unmanaged index that is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. It is not possible to invest directly in an index.
Diversification is one of the guiding principles of portfolio construction, but year-to-date market performance (especially prior to the October correction and the midterm elections) has undermined this well-established approach. The portfolios that have been rewarded as of late are U.S. portfolios concentrated in a few key stocks, global portfolios concentrated in U.S. stocks and asset allocation portfolios concentrated in equities.
An important method for understanding the historical context of these recent conditions is measuring the concentration of asset class performance (i.e., how unusual are the levels of narrow performance?). One tool that can help us measure the breadth of market performance is a diffusion index. Here’s how it works:
This measurement can be used to examine both individual stocks and broad assets in a portfolio. When the result is high, it means that more than half of the securities or assets are doing better than the index. And when it’s low, it means that less than half are doing better than the index.
Using this tool, we looked at the historical level of concentrated performance among 12 different asset classes that frequently comprise a multi-asset approach: U.S. equity, international developed equity, emerging market equity, U.S. Treasuries, international developed Treasuries, emerging market bonds, U.S. investment grade, U.S. mortgage-backed securities, U.S. high yield, global inflation linked bonds, REITs and commodities.
Our analysis revealed that the market was very narrow for most of this year. In this environment, a diversified approach suffers and any kind of risk allocation strategy — which favors lower volatility assets, like bonds, compared to higher volatility assets, like equity — also underperforms.
Why diversification still benefits investors
The obvious question is where do we go from here? Of all the arguments for diversification, the one we believe is most important in this environment is drawdown protection. We are proponents of diversification to help provide downside protection in a portfolio, but consider a diversification approach based on the allocation of risk, not capital.
Risk allocation assigns portfolio weights based on historic asset risk levels and may have a leveraged bond component. And it could improve the drawdown benefit of a globally balanced portfolio. As shown below, bonds and other asset classes mitigated drawdown in the early 2000s. The benefit of this diversified risk allocation approach wasn’t as apparent during the 2008 global financial crisis, but there was a faster recovery from the depths of the drawdown—and this benefited a risk-balance investor in the long term. More recently equity as done so well that a simple global balanced approach has outperformed anything with leveraged bonds (like risk allocation).
Most of 2018 rewarded investors with concentrated bets in equities, and we’ll likely see these periods again. But unless someone can perfectly time the ebbs and flows of the market, the risk of significantly greater drawdowns increases by staying concentrated.
Diversification does not assure a profit or protect against a loss. Past performance does not guarantee future results. It is not possible to invest in an index. The Bloomberg Barclays US Treasury Index includes public obligations of the U.S. Treasury. The Bloomberg Barclays High Yield Index covers the universe of fixed rate, non-investment grade debt. Pay-in-kind (PIK) bonds, Eurobonds, and debt issues from countries designated as Emerging Markets (e.g., Argentina, Brazil, Venezuela, etc.) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, and 144-As are also included. The Bloomberg Barclays U.S. Corporate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market. The Bloomberg Barclays Global Aggregate Index is an unmanaged broad-based, market-capitalization-weighted index that is designed to measure the broad global markets for U.S. and non-U.S. corporate, government, governmental agency, supranational, mortgage-backed and asset-backed fixed-income securities. The Bloomberg Barclays Global TIPS Index consists of inflation-protection securities issued by the US Treasury. They must have at least one year until final maturity and at least $250 million par amount outstanding. The Bloomberg Commodity Index is a broadly diversified index that allows investors to track commodity futures through a single, simple measure. The Bloomberg Barclays Mortgage-backed Securities Index is a market value-weighted index which covers the mortgage-backed securities component of the Bloomberg Barclays U.S. Aggregate Bond Index is composed of agency mortgage-backed passthrough securities of the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac) with a minimum $150 million par amount outstanding and a weighted-average maturity of at least 1 year. The index includes reinvestment of income. The FTSE/NAREIT Index is an index that reflects performance of all publicly-traded equity REITs. The FTSE World Government Bond Index (WGBI) is an index of bonds issued by governments in the U.S., Europe and Asia. The JPMorgan EMBI Global Index tracks returns for actively traded external debt instruments in emerging market The MSCI All Country World Index is a free float-adjusted market capitalization index that is designed to measure equity market. performance in the global Developed and Emerging Markets. The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. The MSCI EAFE Index captures large and mid cap representation across 21 Developed Markets countries* around the world, excluding the US and Canada. The MSCI EM Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.
The Trump administration started down the path of increased tariffs with China in early 2018 by announcing tariffs on steel and aluminum imports and Section 301 tariffs on $50 billion of Chinese imports. Then, on September 24, it implemented tariffs on an additional $200 billion worth of Chinese goods. We believe this path could continue and the imposition of tariffs on all Chinese imports is likely in the next couple of months.
Expect a moderate slowdown on U.S. growth
The consensus is that tariffs will slow growth by approximately 0.2% in the U.S. The impact on inflation will also most likely be manageable, but we shouldn’t be complacent if the magnitude of these tariffs continues to rise and tensions escalate. Tariffs are essentially a tax on imports and will increase import prices for goods in the U.S., including the price of intermediate goods that are used in creating the final products and services that are sold to consumers and businesses. If producers in the U.S. elect to pass on the increased cost of inputs, then we should expect to see a rise in inflation. However, firms faced with higher input costs typically try to find savings elsewhere or they do what they can to absorb the increased costs. Therefore, import costs don’t always equate to a one-to-one increase in the price of final goods and services, and the effect to inflation is expected to be manageable.
Meanwhile, U.S. economic data continues to signal good growth:
• Payroll growth remains strong and is steadily bringing down the unemployment rate.
• Future indicators of growth like the ISM Purchasing Managers Index continue to be elevated, and both consumer and business sentiment is high.
• Wage growth has picked up, although at roughly 3% it’s still moderate by historical standards.
Federal Reserve Board Chairman Jerome Powell recently commented that the economic environment could not get any better than this when growth is strong and inflation is moderate. The Fed also believes that there is little slack in the labor market at a 3.7% unemployment rate. It’s looking to raise the overnight rate steadily, barring any exogenous shocks to the economy. Despite rising bond yields, escalating trade tensions and a slowdown in global growth, U.S. financial conditions have remained supportive of this action by the Federal Reserve.
The U.S. is in a better position than China
The market seems to have also concluded that, vis-à-vis tariffs, the U.S. is in a stronger position than the rest of the world — particularly China. This is reflected in the divergence in U.S. and China stock market performance.
Growth is strong in the U.S., and this trend is likely to continue in the fourth quarter, but it will probably decelerate in 2019 when the positive effects of tax cuts and fiscal stimulus fade. We believe trade tensions and increases in the federal funds rate are here to stay and will be a source of continued market volatility in the near term.
Almost four decades of strong fixed-income returns. From the time interest rates peaked in 1981 through 2017, it was relatively easy to make money in the bond market. U.S. 10-year bonds had:
An equity-like average annual return of 8.3%
Double-digit returns in 13 of those years
Returns of over 20% in four of those years
Only five years of negative returns
The pain of a new rate regime. The U.S. central bank is in the process of removing extraordinary monetary policy that has kept rates at low levels. After decades of declining interest rates being a tailwind to returns, investors will begin to face headwinds. What you’ve always done in fixed income may not work anymore: strategic and active approaches can help address this challenge.
The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Investing involves risk including the risk of loss of principal.