By Diane Tobin, CFA
Chief Operating Officer
The Standard & Poor's (S&P) 500 jumped more than 7 percent in the early days of 2018 on strong earnings growth and optimism surrounding the federal tax cut. But then came an even faster ride down when inflation fears emerged.
Adding to the turbulent conditions in March were rising worries about a global trade war and faster interest-rate hikes. Most key asset classes were negative for the quarter – the exceptions were emerging markets and gold, which were both up 1.5 percent.
USAA Managed Portfolios (UMPs) maintained tactical allocations to international developed markets and emerging markets throughout the quarter. These were based on momentum (continuation of existing market trends) as well as our discretionary models, which consider fundamental valuations, macro conditions and market sentiment.
After more than a year of placid markets, stock volatility returned with a vengeance in late January after an abrupt change of thinking. Global growth and the federal tax cuts went from being hailed as market energizers to being feared as inflation drivers that could quickly push up interest rates.
Such worries aside, actual inflation appears contained -- the Federal Reserve’s preferred measure shows prices continuing to rise at a sub-2-percent annual pace, as they have for the past decade.
The macro environment looks favorable for companies, even though valuations are on the rich side. Earnings growth forecasts have risen significantly since the beginning of 2018, and revenue growth expectations are solid. Upward revisions in corporate earnings may indicate the bull market that began in 2009 has further to run and they support corporate bond values, though stocks could be vulnerable if the Fed gets more aggressive with monetary tightening.
Higher rates may affect bond investors given the inverse relationship between bond prices and yields (bond prices fall as yields rise). So far, the Fed’s half-dozen hikes since late 2015 have pushed up rates for bonds with short maturities. This should be expected given that the Fed heavily influences the short end of the yield curve.
The longer end of the yield curve, however, is controlled by the market and driven largely by inflation and economic expectations. The 10-year Treasury’s yield rose during the first quarter as inflation worries grew. This affected bond prices, but that yield increase was not as much as bonds at the short end. This “flattening” of the yield curve has been the trend during the Fed’s tightening cycle.
As long-term, income-oriented investors, we welcome higher interest rates. It’s true that rising rates will have a short-term negative impact on bond prices, but over time, a bond’s coupon payments account for the vast majority of its total return.
The chart above shows the contribution of coupon payments and price appreciation to the total return for the U.S. bond market over the past 30 years. The dominant component is the income generated by the bonds and reinvested (shown in blue), while the price effect (in green) is a relatively small factor over time because bonds tend to move toward their face value as they get closer to maturity.
Rising interest rates have made bonds more attractive relative to stocks, particularly at the short end of the curve where rates have gone up the most.
For years, income-seeking investors have been buying stocks in order to collect dividends that have been greater than the yield on short-term bonds. The chart below compares the yield on the 2-year Treasury with the S&P 500’s dividend yield.
Beginning when the Fed slashed rates in the aftermath of the financial crisis, the income return of the S&P surpassed that of Treasury bonds for almost a decade. This trend ended in late 2017 and has continued into this year. This is significant for investors, who have the option to reduce their portfolio risk by cutting back on stock holdings without sacrificing income.
Relative performance of our portfolios in the first quarter was helped most by our manager selection in non-U.S. developed market equities. They also benefited from our tactical exposure to emerging market equities, which were among the few asset classes that ended the first quarter in positive territory. Manager selection in U.S. large cap hurt relative performance the most. S&P 500 performance was concentrated among a relatively narrow number of companies. This was a headwind for active managers that didn't own those companies or owned less than the index.
Our key themes:
Developed markets: We favor non-U.S. developed market stocks on a relative valuation basis. Synchronized economic growth around the world stands to help the export-led economies of the eurozone and Japan. These regions are likely earlier than the U.S. in the economic cycle, which could bode well for a prolonged upswing. Accommodative monetary policy may also add to the tailwind.
Emerging markets: Emerging market (EM) stocks followed up their outstanding 2017 by managing to miss some of the downward pressure felt in other equity markets. We see long-term investment appeal for EMs. Their valuations are more attractive than developed markets and their earnings growth is projected to rise faster. The key vulnerability at this point is a disruption to global trade.
U.S. corporate bonds: Volatility has been picking up for high-yield bonds given worries that very tight credit spreads may soon widen. Tight spreads, however, can last for prolonged periods. We think economic growth and improving corporate earnings could support credit. High-yield has also tended to fare well in rising-rate environments due to their higher coupons.
As always, our suggestion to members is to remain focused on the long-term investment plan that you have put so much thought into. For those USAA Managed Portfolio shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations, we suggest consulting with a USAA advisor.
Investing in securities products involves risk, including possible loss of principal.
This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.
Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
The fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss.
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Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.
Standard & Poor’s 500 Index and S&P are registered trademarks. The S&P 500 Index is an unmanaged index of 500 stocks. The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market. S&P 500 is a trademark of the McGraw-Hill Companies, Inc.
Gold is a volatile asset class and is subject to additional risks, such as currency fluctuation, market liquidity, political instability and increased price volatility. It may be more volatile than other asset classes that diversify across many industries and companies.
The Bloomberg Barclays U.S. Municipal Index covers the U.S. dollar-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds.
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