Deteriorating Background Environment

Posted On:

  • Two of the most important areas to evaluate at this midpoint of the year are raising interest rates and the weakness of global stock markets.
  • Most regions of the world have been impacted by slowing economic growth in emerging markets and China, and increasing concerns that an ambitious program by Japan to stimulate their economy could cause currency instability between countries.
  • While it is uncertain if this may be a temporary pause, or the start of a more significant decline, we have entered a time when risk management is probably as important as it was back in 2006 and 2007.

2013 has been strong for the U.S. stock market as fears of a Fiscal Cliff and Government Sequester did not turn out to have the negative impact that many people had feared.  However, most other asset classes have experienced a much more sobering performance profile so far this year, and could be sounding warning signs for our stock market.

Two of the most important areas to evaluate at this midpoint of the year are raising interest rates and the weakness of global stock markets.  Interest rates have been kept low by the Federal Reserve through policy and through bond purchases which are designed to lower rates on longer-term bonds where their rates are typically set by market forces and expectations of inflation and economic growth.

These purchases of longer-term bonds are expected to reduce borrowing costs for home mortgages and corporations borrowing money, all of which should be stimulus to the overall economy.  These policies have brought down interest rates to very low levels relative to inflation and at some point they will revert to more normal levels.  We have been seeing a modest upward drift in interest rates over the past year, but over the past couple of months, the trend moved from drifting to spiking higher as the yield on 10-year Treasury bonds moved from 1.66% on May 1st to 2.73% on July 5th on concerns that the Federal Reserve was nearing an end to its current bond buying program (1).  The result has been a sharp decline for most bond investors, particularly for those holding treasury bonds.  Returns for the various bond asset classes are as follows:

Long-Term Treasury Bonds  -7.84%
Intermediate-Term Treasury Bonds  -4.02%
Treasury Inflation Protected Bonds  -7.21%
Aggregate Bond    -2.54%
High Yield Corporate Bond   -.09%
Bank Loan    1.39%
Source:  NYSE Arca

Needless to say, the rise in interest rates has caused our income-oriented programs to become much more defensive, and we are currently holding significant amounts of cash.  In addition, we have added positions in adjustable-rate bonds and inverse bond funds in some of these programs currently.  In the June market commentary I discussed our expected response to rising interest rates, and if you did not have a chance to read it, it can be found on our website under the “Market Insights” tab.  I will just follow up by saying that while the increase in interest rates causes us to hold more defensive positions which typically pay us little or no interest while we wait.  However, it typically does give us the opportunity to come back into markets and buy investments at more attractive interest rates and prices, and I would expect to see some of these opportunities over the coming months.  In regard to the impact of rising interest rates on the stock market, historically, rising interest rates have been a negative for stocks.  However, with rates moving up from such low levels it is unlikely the current rise in interest rates will become a significant issue for the stock market unless rates move back above historical ranges relative to inflation.

The performance of foreign stock markets this year has been quite perplexing; the year-to-date returns for selected countries and regions is as follows:

United States +13.75%
Canada  -6.84%
Europe    +.91%
Asia   -6.72%
Latin America -14.63%
China  -17.44%
Source:  NYSE Arca

Europe has performed modestly positive due to their recession slowing and the possibility that they may emerge from their recession early next year.  However, most other regions of the world have been impacted by slowing economic growth in emerging markets and China, and increasing concerns that an ambitious program by Japan to stimulate their economy could cause currency instability between countries.  On July 9th the International Monetary Fund reduced their estimates of global growth for both 2013 and 2014 (2).  While this slowdown in economic growth has weighed on many of the world’s stock markets, it has not materially impacted the U.S. stock market….yet.

The PIMCO Secular Outlook
Each year PIMCO, the largest bond money management firm in the world holds a multi-day conference to update their secular outlook for the next three-to-five years, and I thought that the commentary published by Mohamed El-Erian, the CEO of PIMCO after the conference is insightful in highlighting a couple of key points that are important to consider as we move through the next few years.

“I must admit that going into this year’s discussion; I found the context even more challenging than usual.  Indeed it was the most complex since I first joined PIMCI in 1999.  This complexity is not just due to a global economy in the midst of multiple historical realignments.  It is also because highly experimental central bank policies have disconnected most asset prices from the complex ecosystem.”  Emphasis added.  One of the biggest challenges that we have had over the past few years in managing the investment strategies is that many asset classes and risk/reward relationships are not behaving the way that they have typically done in the past.  This is largely due to the central banks implementing policies that are designed to impact the financial markets and create a “wealth effect” that stimulates economic growth.  This has caused us to become defensive at times that have historically provided negative returns for various types of investments, but in the current environment the period of above-average risk often passed with either a much more brief and shallow decline, or in some cases no decline at all.  Yet, the fact remains that in many assets, prices are above what would normally be expected in similar economic conditions.

The commentary goes on to state ”By venturing deep into experimental policy territory, and by remaining there for quite a while, central banks have tried to support growth and counter financial instability, thus buying time for economies to heal endogenously and for politicians to deliver on their policy responsibilities.  In the process, they have inserted a remarkable wedge – a disconnect – between market prices and underlying economic and financial fundamentals… Investors are enticed to take more and more risk at ever more elevated prices”.  Rising prices are typically good, but when the prices rise more than the underlying fundamentals can justify in the long-term it is important to realize that the aftermath can easily be the same as what happened to internet stocks in the late 1990’s or to real estate in 2007-2008.  It is okay to enjoy the party, but you need to have a good exit plan.

In discussing investment implications the commentary notes “Do not lose sight of the extent to which asset prices have been disconnected from fundamentals and, thus, require major eventual validation by fundamentals.”  In addition he notes the importance of evolving risk management approaches “Correlations have and will continue to change in this fluid world heavily impacted by central banks.  Diversification, while necessary, is no longer sufficient for portfolio risk mitigation.”  We agree that diversification across asset classes is helpful in reducing risk in a normal environment, but when significant market events happen diversification alone has become less effective in preserving portfolios, which is why we continue to believe that having the flexibility to fully move out of asset classes in times of high risk and go to the safety of short-term bonds, cash and other defensive areas will continue to serve us well as we move through the coming years.

Probably the most important point I would like you to consider was found in his concluding remarks and are as follows  “Back in 2006, PIMCO rejected the consensus view of a “great moderation” (and “goldilocks”) in favor of the concept of a “stable disequilibrium.”  Specifically, we argued that stability on the surface was accompanied by weakening and increasingly unstable underpinnings.   Our concept of stable disequilibrium is back.  Whether it is due to a lack of timely understanding, an insufficiently agile political system or imperfect policy tools, the collective response to the unusual multi-speed dynamics of the last few years has added this concept to the dynamic characterization of the New Normal.”

While it was nearly two years after PIMCO’s identifying the period of above-average risk that the financial markets witnessed their massive declines, the identification of the increasing risk helped them to moderate some of the losses that may have otherwise occurred.  Based upon the increasing risk that we, as well as PIMCO and some others are seeing, it is time to be increasingly careful about the amount of risk that is being taken on in investment portfolios.  We and most of our sub-advisors have been turning increasingly defensive over the past few months.  While it is uncertain if this may be a temporary pause, or the start of a more significant decline, we have entered a time when risk management is probably as important as it was back in 2006 and 2007.

Michael Ball
Lead Portfolio Manager

 

Sources:
(1) Federal Reserve Bank of St. Louis
(2) 
http://www.imf.org/external/pubs/ft/weo/2013/update/02/

Disclosure:  Opinions expressed are not meant to provide legal, tax, or other professional advice or recommendations. All information has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities or instrument or to participate in any particular trading strategy.  Investing involves risk, including the possible loss of principal.   All opinions and views constitute our judgment as of the date of writing and are subject to change at any time without notice.  Investors should consider the investment objectives, risks, charges and expenses of the underlying funds that make up the model portfolios carefully before investing.  The ADV Part II document should be read carefully before investing.  Please contact a licensed advisor working with Weatherstone to obtain a current copy.  Weatherstone Capital Management is an SEC Registered Investment Advisor with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940.  Weatherstone Capital Management is not affiliated with any broker/dealer, and works with several broker/dealers to distribute its products and services.  Past performance does not guarantee future results.