Both bonds and stocks have moved higher recently, but it’s not clear how long they can keep moving in tandem. Meanwhile, inconsistent economic data have fueled continued uncertainty about when or whether the Federal Reserve might raise interest rates. Viewpoints checked in with Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets’ fixed income division, about his take on the current economic and market environment—and why investors may want to be cautious when searching for yield.
|Q:||How have bonds performed recently?|
DEMARCO: On a total return basis, which includes reinvested dividends, the Barclays Long-Term Treasury Index has returned 14.6% over the past year while the S&P 500® Index has returned 6.4% (as of August 18.) The bond market has been positively correlated with the stock market over the past year—which is unusual for any length of time—and this recent correlation, in my opinion, is due to central bank policies. In mid-August, all three major stock indexes—the S&P 500, the Dow Jones Industrial Average, and the NASDAQ—hit record highs, despite an ongoing earnings recession and declining expectations for U.S. GDP (gross domestic product) growth. Meanwhile, investment-grade bonds, as measured by The Bank of America Merrill Lynch Global Bond Index, are up 5.8% year to date (as of August 18), while high-yield bonds are up 14%, according to the Bank of America Merrill Lynch High Yield Master II Index.
|Q:||How is the economy doing?|
DEMARCO: The economy continues to be fueled by the consumer. In the second quarter, consumer spending was the primary driver of economic growth. The economic numbers, however, continue to be inconsistent. We recently saw core retail sales dip, and the Bureau of Labor Statistics released significant downward revisions on second quarter wage data. Lower incomes pushed the savings rate down to about 5%, which is a threshold where we have often started to see lower spending in the post crisis period. Perhaps that helps partly explain the unexpected weakness in July retail sales figures.
The housing and labor markets continue to be the bright spots in the economy. That said, the labor market by some measures is confounding, considering how many years into a recovery we are and suggests further slack remains. According to Bloomberg, since 2000, the participation rate for people 65 and older has risen from 12.6% to 19.5%—the highest level since the early 1960s—and the labor participation rate among workers 55 to 64 has risen 4.2 percentage points. Meanwhile, the participation rate for all younger age groups has actually dropped 3 percentage points. What’s more, participation has risen 3.5 percentage points among the least educated, but has dropped 5 to 8 percentage points for those with diplomas or degrees. And a significant portion of new jobs are in low-paying sectors, which helps explain why wage pressure has been slow to build some seven years into an economic recovery. So while the labor market expansion remains the main green shoot of the economy, some undertones make it more difficult to be confident about the continued strength in the labor market at this stage in the economic cycle.
|Q:||If these inconsistent economic results continue, how might the Fed respond?|
DEMARCO: Markets are pricing in the odds of a September rate hike at only about 20%, and a rate hike by December at about 46%. My stance has not changed; I am still leaning toward the possibility of one more rate hike this year (December). That said, there is plenty of data that can come in between now and then that could drive the likelihood of one or more rate hikes higher.
The statement from the Fed’s July 27 meeting was somewhat hawkish, and suggested that the near-term risks for the economic outlook had diminished. It mentioned the strength of the labor market several times and slightly upgraded comments on economic activity and household spending. That statement was largely ignored by the markets at the time. The minutes to that meeting were released on August 17, and the details were more nuanced. While the Federal Open Market Committee (FOMC) meeting minutes revealed (as I interpreted them) a divided committee with a somewhat more vocal group cautioning patience. While the FOMC cited ”diminished downside risks” with the employment bounce-back in June and lessened Brexit fears, this has to be viewed in the context of minimal signs of inflation hitting its target and the recent low-growth GDP trajectory (1.2% over the past four quarters). I’ll be watching for comments from Fed Chair Yellen at the end of August, during the Jackson Hole Economic Summit. I believe that if Yellen wants to prepare the markets for a rate hike this year, that would be an opportune time to start laying the groundwork.
|Q:||What’s your outlook for bond yields?|
DEMARCO: I think yields may remain lower for longer, unless we see more aggressive fiscal policy. Monetary policy is becoming less and less effective. If the baton gets passed from solely monetary policy to fiscal policy in the form of, say, large-scale infrastructure programs, it might shake us out of the rate regime we’re in—or at least accelerate inflation expectations somewhat. Both presidential candidates have called for infrastructure spending, but actually pushing those types of plans through Congress may be difficult. So this is the biggest wild card for me in terms of the path of interest rates.
|Q:||How have bond investors responded to this unusual environment?|
DEMARCO: We continue to see strong flows into bonds, particularly in the U.S., as investors search for income. That demand has helped prop up U.S. bond markets. The global market value of bonds has jumped by $2.5 trillion this year, with $1 trillion of that increase coming since May according to Bank of America Merrill Lynch data.
Lower-quality and longer-duration bonds have largely outperformed higher-quality and short-intermediate issues in general. While the search for yield is understandable and predictable, I believe that investors should exercise great discipline at this juncture of where rates and spreads reside.
|Q:||Do you have specific concerns about lower-quality bonds?|
DEMARCO: A number of things worry me. I believe we’re late in the credit cycle, with the economy just plodding along and credit fundamentals deteriorating. Leverage is back up to pre-2007 levels, overall earnings are weak (declining, actually), and rates are likely to move higher at some point. Covenant quality (the terms of a loan) on bond and loan deals is near an all-time low, meaning there are weaker protections for investors. But because interest rates are so low, many investors may be ignoring these issues and seeking out riskier segments of the market. I don’t think this is a good long-term strategy.
|Q:||Where are you finding opportunities?|
DEMARCO: In both the investment-grade and the high-yield market, I look for “higher-quality” names that offer predictable cash flow and strong capability to service their debt. As long as economic growth remains positive, this should favor the corporate sector. Sectors I am focusing on right now include media, building materials, paper, REITs, large U.S. banks, and financial services, to name a few.
Some income investors have shifted their focus to dividend-paying stocks, and it’s true that more than 60% of the stocks in the S&P 500 have dividend yields greater than the yield on the 10-year U.S. Treasury bond. But it’s also true that stocks carry a lot more volatility than high-quality bonds. For investors in higher tax brackets, municipal bonds also offer value, especially when looked at on a taxable-equivalent basis.
This is an interesting time to be a bond investor. I believe that fixed income always should be part of a diversified portfolio, because it can act as a sort of shock absorber in times of economic stress. Yet with yields at such extreme lows, the potential for further price appreciation is somewhat limited, in my opinion. Bond investors should therefore consider taking this opportunity to review their holdings and assess their weightings to individual names and sectors.
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