Insights: Febraury Continues the Year’s Strong Start

February continued and broadened the positive price momentum that characterized January. Economic indicators are broadly solid or improving both here and abroad. Positive movement in asset prices reflects those facts and increased optimism for additional improvement. The Federal Reserve has signaled that it may raise interest rates again as early as later this month, in recognition of underlying economic health and firming inflation. The political transition in the U.S. continues, as does the uncertainty that accompanies it.  We focus this issue of Insights on two domestic topics: (1) the future portfolio effects of rising interest rates and inflation on core bonds, and (2) how investors should assess the recent record highs that the S&P 500 has reached.


Both U.S. and international equities, as well as high yield and emerging market bonds, were up notably during the month. Core U.S. bonds were also positive but modestly.

The S&P 500 Index rose 3.97% in February, and small capitalization stocks in the Russell 2000 Index gained nearly 2%, as did both U.S. dollar-denominated and local currency emerging market debt. Emerging market stocks advanced 3%.


Improving economic data and upticks in consumer and investor optimism have lifted both recent inflation indicators and equity prices.  How should investors take these developments into account as they consider their portfolios? Our view, as we will explain below, is that gains in realized and expected inflation are of the “good” inflation variety and are modest enough to remain well-contained.  The mere fact that major domestic equity indices like the S&P 500 and Dow Jones Industrial Average have notched all-time-highs is not by itself cause for concern. While a stock market correction could occur, and would probably be healthy, valuations are not overly stretched by historical measures, and price gains reflect expectations for additional economic expansion within a supportive business and regulatory environment.

First, let us turn to the current state of the core bond market along with the two important factors of Federal Reserve policy and inflation.  The latest inflation figures, which date back to the end of January, show that headline inflation and core inflation are both below the 50-year average.  (Core inflation excludes the volatile food and energy components.)  This stretch, however, includes the hyperinflationary periods in the 1970s and 1980s.  Therefore, it is best just to look at the year-over-year change figures in the Jan. 2017 column relative to (a) the Fed’s long-term inflation target of 2.0% and (b) in light of the fact that up until roughly the start of this year inflation in the U.S, both core and headline figures, have been running well under the 2% level.  In order to maintain long-term price stability, which is the Fed’s mandate, it may be incumbent upon the Fed to let inflation run marginally higher than its target level in order to compensate for the extended period of “under-inflation.”

This is to say that, although inflation is higher both now than it has been in recent years and higher than the long-term target, we believe that inflation is presently not cause for great concern. As you can see in the chart below, since the Fed set its 2% target, inflation has run below that level.  The Fed has over that time been much more concerned about under-inflation than hyper-inflation.  It still is.  This is a key reason that the Fed has consistently maintained that it will take a “measured” approach to raising rates.  It wants, on the one hand, to recognize that the economy has strengthened and can sustain higher interest rate levels, and, on the other, simultaneously to pursue interest rate normalization responsibly after having “undershot” its target over the last 5 years.

You may have noticed in the table on page 2 that the year-over-year energy component has risen more than 10% through January.  This large number ought to be viewed through the lens of the recovery in energy prices since oil and other such commodities dropped precipitously at the tail end of 2015 and began 2016 with additional declines.  Those prices began to recover starting in mid-February last year, and so the elevated energy price component (which is part of the headline number, not part of the core number) really just reflects the recovery that has taken place not only in energy prices but equity asset prices generally. To cite one example, crude oil prices, now at $52 a barrel, are 100% higher than where they were 1 year ago, but they are still 50% below their 2014 levels, when they were around $105 a barrel. This is part of a recovery for energy-related prices; it is not a break-out from an already high level.

Something else has occurred during this period of energy-price recovery and equity asset price appreciation against the backdrop of firming global economic fundamentals.  That is a rise in both core bond yields and interest-rate sensitivity (or duration).  We have commented before, including in last month’s Insights, about the need for investors to maintain bond exposure for diversification purposes but to shift some of that bond exposure away from the increasingly interest-rate sensitive traditional core fixed income areas represented in the Barclays U.S. Aggregate Bond Index.  The chart below illustrates that traditional core taxable bonds have added price sensitivity to interest rate moves since the end of the global financial crisis in 2009.  Because we agree with the Fed that the U.S. economy is on much more solid footing now than it was back in 2009 and can sustain measured interest rate increases, we have reduced our core bond exposure significantly for clients and added to unconstrained bond fund strategies, which we believe can help portfolios maintain low volatility and diversification against equity risk while also mitigating full core bond sensitivity to interest rate increases.

Traditional bonds such as those in the Barclays U.S. Aggregate Bond Index now have lower yields and higher duration than they did in 2009.  Now that the Fed has begun to raise rates, the yield levels of such traditional core bonds are at low levels that may not necessarily offset the price declines related to their sensitivity to those interest rate increases.

At the same time, we wish to remind clients that a bad year for bonds means something very different from a bad year for stocks.  Comparing the steepest calendar-year drawdowns dating back to the start of the Barclays U.S. Aggregate Bond Index in 1976 for both bonds and stocks:  in 1994, bonds lost nearly 3%; in 2008, stocks lost 38%.  To simplify viewing of this comparison graphically, the chart below shows that drawdown history from 1990.

The point is that investors should be cognizant of the risks related to bonds in a rising interest rate environment, but they should also not throw the baby out with the bath water and eliminate bonds altogether because of their principal protection role in diversified portfolios.  It is precisely because we are keeping both of these aspects in mind that we have reduced duration risk and shifted some assets from core bonds to unconstrained strategies, but we have not eliminated completely either core bonds or all bonds.

Second, we understand that when the press announces that stock indices are trading at all-time highs some investors may ask if the market is too euphoric or if stocks are overvalued.

Regarding all-time highs, we think it is important to note that, although the term “all-time high” may bring to mind visions of stock market euphoria, such a condition is far from the case now.  In fact, it is the natural trajectory for stock markets to push towards all-time highs. A capitalist system generally produces revenues and earnings that grow, rather than diminish, over time.  Just because a stock market is at all-time highs does not necessarily mean that it is a bad time to invest or that a downturn is just around the corner.  Long-term historical data can suggest quite the opposite, in fact.

We have stressed in past commentaries that investors need to take the long-term perspective when it comes to equity market returns.  The following table illustrates another reason why.  Based on return history extending back to 1950, the data show the frequency of positive returns from the S&P 500 index of large company stocks over one month, one year, and five year time periods.  In short, over one month, that stock market had a 59% chance of going higher.  Historically, it was slightly better than a coin flip odds on whether the market would go up or down in any given month.  Yet if you stretch the observation period out to a year, the frequency of a positive return increases to 72%.  If you have five years to wait, the frequency of a positive return increases even further to 81%.

If you look at these same metrics after the market hit an all-time high, the numbers do not change significantly. In fact, over the five-year period the frequency of positive stock returns was slightly higher after the market hit an all-time high than during the full observation intervals: it was positive 83% of the time.  When the market hit an all-time high, the S&P’s following one year return was similarly positive 72% of the time.  In short, the stock market’s hitting all-time highs has not historically affected an investor’s chances of generating positive future returns in that market.

Second, concerning valuations, the S&P 500 currently trades at 16.9x forward earnings, which is 6.2% above the 25 year average of 15.9x.

Other measures, such as price to book or price to cash flow show the market trading at a slight discount, or in line, respectively, with average valuations.  The stock market is not even close to the nose-bleed valuation levels experienced during the tech bubble in the late 90’s.  Given the upturn in economic activity, low interest rate levels, improving corporate earnings and the potential for economic stimulus from the government, we believe that the current valuation multiple of the equity market is elevated above recent levels, but is also justifiable.

To be sure, the market could experience some volatility in the near-term if the Fed begins to signal more aggressive rate hike plans than the market anticipates.  There could also be political turmoil that upsets the market.  Markets usually experience corrections of 10% or more in any given calendar year, and it is prudent to expect pullbacks from time to time.  However, we do not believe that those facts are sufficient reason to try to time the market or to feel skittish about recent gains, because the underlying fundamentals of the economy are on solid footing.

In summary, inflation has picked up over the last year, but is still below long-term historical averages.  The turnaround in inflation metrics has been driven by a rebound in energy prices from extremely low levels last year, combined with an uptick in measures of “good” inflation such as wages and house prices.  The push higher in inflation has received notice from the Federal Reserve, which is indicating increased willingness to raise rates at its March meeting.  Given the low coupons offered on traditional bonds, we believe that investors are well served by having exposure to unconstrained and corporate credit strategies within their portfolios.  Regarding equity markets, though the financial press has made much of the stock market hitting all-time high levels, we caution investors to keep a level head.  Markets often hit all-time highs and investors are best served by keeping a long-term perspective on their portfolio allocation.





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