Portfolio Allocation Amid the Tidal Effects of Renewed Fed Easing
The Fed is poised to join the global easing bandwagon, fueling a surge in risk asset prices. As market distortions from easy money grow, so does the importance of security selection and portfolio allocation.
Markets fully expect the U.S. Federal Reserve to cut its benchmark rate at the end of this month for the first time since 2007, and the main question debated among Fed watchers is whether it will reduce the Fed funds rate a quarter or a half point.
Two other questions, though, should be of greater importance to investors. Does the Fed, which insists that it remains data dependent in conducting monetary policy, actually need to cut? The upper bound of the target rate, at 2.5%, is still less than half of its level 12 years ago. Secondly, how should investors think about portfolio allocation in a world of low, and in some places, negative policy rates?
U.S. economic conditions don’t necessarily indicate more Fed stimulus is needed when policy remains at historically accommodative levels. Take a look at the data. First-quarter economic growth clocked in at 3.1%, and while it’s expected to slow to 1.8% in the second quarter, full-year 2019 GDP is currently forecast to grow a quite decent 2.5%. At 3.7%, unemployment is at a five-decade low, and annual wage growth is up 3.2%. Consumer spending is slated to run 2.4% in 2019. U.S. equity indices have been hovering at record highs and financial conditions, as measured by the Chicago Fed, are near record “loose” lows.
To be sure, the front end of the yield curve inverted in the spring. Historically, that’s a signal recession is likely in the next year or so. Core PCE, the Fed’s preferred inflation measure, has recently been measured at a plodding 1.6%, which is below the monetary authority’s 2% target. Importantly, five-year forward inflation expectations have also been coming up short of late. Private non-residential fixed investment has been slipping as well. Fed Chairman Jerome Powell pointed to economic risks from trade disputes and slowing global growth as a big focus of concern.
The eurozone has seen significant deceleration in growth after energy prices spiked in the first quarter, and exports to China, which hit its slowest growth in three decades in the second quarter, dropped. Speculation is growing that the European Central Bank could lower in the next month or two its already negative key rate and possibly restart bond purchases after ending them last December. Much will depend on whether Germany’s sluggish economy, the region’s largest, stalled in the second quarter.
An “Insurance Cut”
New York Fed President John Williams seemed to suggest on July 18 that a bigger, 50-basis-point cut was in order, while Fed Vice-Chairman Richard Clarida the same day said the Fed should cut preemptively, before the economy loses steam, so that growth stays “on an even keel.” Clarida told Fox Business News: “You don’t need to wait until things get so bad to have a dramatic series of rate cuts.” The Fed, he added, “needs to make a decision based on where we think the economy may be heading, and, importantly, where the risks to the economy are lined up.”
Perhaps those risks aren’t quite as balanced as the Fed would like, so an “insurance cut” is in order, as Federal Reserve Bank of St. Louis President James Bullard, a voting member of the Fed’s monetary policy board, has advocated in recent comments to financial media. Bullard explicitly argued that a quarter-point reduction would be appropriate at the July meeting. Interestingly, after Williams’ remarks last week, the NY Fed issued a statement tempering them, whipsawing markets that had priced a 50-basis-point cut back to a 25-basis-point baseline.
In any event, what if the risks to the U.S. and global economies come more from frothy, out-of-sync financial markets, which have been driven by extraordinarily low or negative developed world rates?
Since Powell’s increasingly dovish turns in January and again in June, the S&P 500 Index has produced a year-to-date total return of 20%, despite what’s shaping up to be two consecutive quarters of corporate net profit margin declines. Meanwhile, the Bloomberg Barclays U.S. Aggregate Index has returned 6.2% so far in 2019. The positive correlation is unusual but then again much the same dynamic is evident in overseas markets, where other central banks have already cut policy rates nearly 20 times in 2019 and market distortions in some regions have mushroomed.
Negative-Yielding Corporate Bonds; Negative-Yielding Junk?
Given the monetary gusher from low and negative policy rates, the stock of outstanding negative-yielding developed market bonds has ballooned to nearly $13 trillion, according to Bank of America Merrill Lynch, which also notes that more than a quarter of European investment grade corporate bonds now sport negative yields. Bizarrely, more than a dozen euro-denominated junk bonds trade at negative yields, according to Bloomberg, meaning investors pay, rather than being paid, to assume default risk on speculative-grade paper.
What’s the downside protection, not to speak of return potential, in fixed income in this unprecedented market environment? It’s hard to tell. As Thornburg CEO and Portfolio Manager Jason Brady points out, “accommodative monetary policies have driven risk-free rates to levels so low that they don’t create a reliable foundation from which to price risk assets. Do yields accurately reflect risks?”
The question is crucial for investors looking to generate alpha, or excess return, which we believe can best be had by strong individual security selection and sound portfolio allocation. So, as the Fed undertakes an insurance cut, investors ought to consider whether high-quality, very expensive, low- or negative-yielding fixed income provides the portfolio insurance it should. They should also weigh prospects for equities experiencing price gains on expanding valuation multiples, rather than earnings.
Opportunities for upside capture and downside protection always exist among carefully selected stocks and bonds. But it’s important to identify the relative value between them. Thornburg CIO Brian McMahon notes, for example, that Royal Dutch Shell’s 0.75% coupon bond due in 2028 currently trades at a premium, to yield just around 30 basis points. By contrast, the dividend yield on its equity stands around 5.75%. Shell is repurchasing its stock, not only reducing the net dividend payout expenditure ahead, but also potentially supporting its share price via a reduced number of outstanding shares.
What kind of ballast might a Shell security provide to a portfolio? If past is prologue, it may be instructive to examine the market rout last December, when Shell’s ADR shed 3.5%, while the MSCI EAFE Index fell 5%, and the S&P 500 dropped 9.2%. The price on that 2028 0.75% coupon bond rose to EUR95.615 from EUR94.695. Not bad, but its bond yield still paled in comparison to its equity yield. True, both the S&P 500 and the MSCI EAFE have outperformed Shell’s stock so far this year. But this kind of insurance can not only enable a portfolio to participate in up markets but also bolster it when the inevitable downdrafts blow through, helping it compound off a higher base.
Market volatility, as measured by the CBOE Volatility Index, has been trending down over the last few months. The VIX, as it’s known, recently stood at 14.5, which is below the 12-month 16.4 average and the 36.1 high last December. But the newly rising tide of central bank liquidity inflating asset prices can make for a weak foundation supporting the equity and bond price gains. History suggests volatility can return and spread quickly, particularly when excesses in risk asset markets proliferate.
Benchmark agnostic, flexible portfolios populated with highly select, attractively priced stocks and bonds can be greater than the sum of their parts. Both the individual merits and broader portfolio fit of each security should reflect differentiated, but complementary risk and return characteristics, helping position a portfolio to better manage the inevitable turns of market tides.