U.S. Economy: Not an Environment for Aggressive Monetary Policy Tightening
It’s been said, and feared, for years that U.S. interest rates will quickly rise once the Federal Reserve starts to reverse course, resulting in declines in the prices of fixed income securities. Since the infamous “Taper Tantrum” in mid-2013, the Federal Reserve has been carefully trying to step away from the unprecedented easy money policy it has employed since the financial crisis. Yet, the power of the U.S. to act in isolation has diminished over the past decade.
With major economies outside the U.S. continuing to experience tepid growth and inflation, and a mixed recovery taking place in the U.S., fundamentals and technicals both suggest this will not be the case. Compared to the rest of the world, the United States appears to be on better footing — but not by much.
On the positive side, the labor market has improved significantly in recent years, illustrated by a substantial decline in the unemployment rate and increase in labor force participation. U.S. growth, however, paints a less rosy picture and inflation statistics are still running below the Fed’s target. According to the latest data release, the U.S. economy grew at an annualized pace of just 1.1% during the second quarter of 2016. Real wages have increased, but gains have not been as strong as in past cycles when unemployment was this low. Despite higher wages and a recovery in single family housing, consumer spending remains muted even in spite of the effective rebate from lower gasoline prices. Since consumption accounts for about 70% of U.S. GDP today, it’s hard to envision a scenario where GDP can rise meaningfully without stronger wage growth.
Finally, and perhaps most importantly, productivity has yet to improve in the period after the financial crisis. Productivity, as measured by annual output per hour, had averaged 0.5% over the past five years compared to a 20-year average of 2%.2 Although the Federal Reserve raised the federal funds target rate for the first time in nearly
10 years in December, monetary policy remains extremely accommodative by historical standards. Looking at the U.S. economic backdrop in isolation, these are hardly conditions warranting aggressive monetary policy by the Fed.
Another fallacy, we believe, is the expectation that the U.S. is on a path to decouple from its developed-market peers. Given the interconnectivity of global economies and corporations today, decoupling is not something we anticipate — even assuming improvements in U.S. economic data. As the Federal Reserve has attempted to move in the direction of normalizing policy, one constraint has been an increase in the value of the U.S. dollar. In 2015, the strengthening of the U.S. dollar hurt corporate revenues as more than 40%3 of Standard & Poor’s 500 companies’ total revenues are derived from abroad. In the fourth quarter of 2015 alone, North American companies lost $33.9 billion in revenues due to currency translation, the largest impact in almost five years.
Cross-market valuations between U.S. Treasuries and the sovereign debt of other developed-market nations are also keeping U.S. rates anchored. It’s not just negative policy rates that have become more common — negative yields extend out to longer-dated sovereign debt as well. Government bonds in Germany have negative yields out to nine years in maturity, and it’s not until the 20-year point of the Japanese government curve that yields are positive.
By comparison, the 10-year U.S. Treasury at 1.49% doesn’t seem so bad. In fact, a whopping 84% of J.P. Morgan’s developed-market sovereign debt index currently yields less than the 10-year U.S. Treasury.4 This statistic was below 50% as recently as late 2013 and has steadily climbed since that time. Furthermore, over 37% of the index’s constituents have negative yields.5
The relative attractiveness of U.S. Treasuries suggests funds will continue to flow to dollar-denominated assets and keep a lid on U.S. rates.
In addition to the fundamental and technical factors outlined above, history tells us that there is a recency bias where too much emphasis is placed on the recent past in terms of expectations for the future level of interest rates. Longer tenured investors in today’s markets remember when U.S. interest rates exceeded 10% in the early 1980s and have seen yields steadily decline over the ensuing decades. While rates have been expected to rise for years, recency bias leads to the bearish view that rates must “normalize” soon.
Looking further back in history, however, tells a different story as to what “normal” is and provides helpful context for today’s low-interest rate environment. Immediately following both the Long Depression of the 1870s and the Great Depression that began in 1929, U.S. interest rates remained low by historical standards for 31 and 32 years, respectively. In the 31 years following the Great Depression, the 10-year U.S. Treasury note yielded an average of 2.78%. When taking this longer-term perspective, the eight-year span of low rates since the 2008–2009 global financial crisis seems short by comparison.
The investment environment of the post-post-crisis era — namely one of low growth, low inflation, low interest rates and low potential returns from risk assets alongside higher volatility — has important implications for fixed income investors.
Don’t be afraid to own duration. For the reasons described above, we expect rates to remain low for a lot longer. The United States’ relatively healthier trajectory compared to other major economies does not necessarily mean rates will rise meaningfully in the coming years. The Fed’s path to normalization will remain very gradual and will continue to respond to the strength of the U.S. dollar as well as unforeseen developments in the U.S. and abroad. Investing in core fixed income as part of a balanced portfolio is a crucial need in today’s unprecedented, uncertain environment.
Watch for scope creep. The persistent low-interest-rate environment post-crisis has dramatically changed investment manager behavior. Seven years at the lower bound of interest rates has incentivized managers to reach further out on the risk spectrum in order to find higher yields and better return potential. It’s for this reason that many core fixed income funds hold significant amounts of high yield bonds today.
While this behavior was rewarded in the low-volatility, risk-on market dynamics of the post-crisis era, fixed income portfolios invested in this way will be too highly correlated to the equity market to be considered “core fixed income,” in our opinion. This is because high yield bonds exhibit a strong positive (+0.8) correlation to the equity market. While many financial advisors tend to focus on historical returns and fees in selecting managers, we suggest including a filter for equity correlation as well.
In times of volatility like earlier this year, it’s exceedingly important to invest in bond funds that behave like bond funds. Specifically, core fixed income investments should lower overall portfolio return volatility and serve as the anchor to a balanced portfolio in times of equity market stress. Protecting your portfolio against potential equity market volatility is especially important when considering equities are in their eighth year of a bull market despite a more recent struggle in corporate earnings growth.
Tax-exempt bonds are not just about taxes. Currently, the tax-equivalent yields on municipal bonds are meaningfully in excess of their taxable counterparts. In addition to their tax advantage, though, tax-exempt bonds possess additional attractive qualities that enable them to add value to a core fixed income portfolio. Tax-exempt funds have not only demonstrated low historical correlation to the equity market but can also provide diversification in terms of return sources.
Because tax-exempt bonds are issued by state and local municipalities, they are largely insulated from the global dynamics that have recently caused volatility in the taxable bond and equity space, including concerns about China and the strong U.S. dollar. In addition, the decline in commodity prices has largely been a tailwind for municipal issuers as lower commodity prices mean projects have become cheaper and driving has become less costly, helping transportation credits such as toll roads.
A 3% to 4% yield on your fixed income portfolio is a win. With today’s lower total return expectations, we believe a diversified portfolio that yields 3% to 4% is achievable without taking on undue equity-like risk. With the Bloomberg Barclays U.S. Aggregate Index yielding just 1.9% today, one might be tempted by a large allocation to high-yield bonds in order to achieve that 3%–4% yield target.
While some allocation to the high-yield market is warranted given its income profile, high-yield bonds, as noted above, exhibit a strong positive correlation to the equity market. For that reason, we believe high-yield bonds should occupy only a small position in a fixed income portfolio or even be viewed as part of an individual’s equity allocation. Rather, we would suggest including allocations (in taxable accounts)6 to municipal bond funds as the way to pursue a higher portfolio yield, as municipal bonds can offer attractive tax-equivalent yields in excess of core taxable strategies. Compared to a short-term taxable fund, short-term muni funds offer about 1% more tax-equivalent yield.7 In the core space, a typical muni fund’s tax-equivalent yield is about 0.9% higher than its taxable counterpart.8
High-yield municipal bond funds currently yield over 7% on a tax-equivalent basis, assuming the highest tax bracket, although we would note that the range of yields in this category varies greatly.9 An added benefit of including municipal bonds — especially compared to taxable high-yield bonds — is that they may not increase the correlation of the fixed income portfolio to the equity market. The five-year correlation of core and high-yield muni funds to the S&P 500 has been close to zero.10