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Financial Industry Insights from Advisors Asset Management
On December 12, 2016
AAM Viewpoints - It’s Time to Review Your Portfolio
As we entered 2016, many of us were expecting the Fed to raise short term rates and to see a move up in yields (the U.S. 10 year Treasury started the year at 2.27%). After the Brexit vote in July, we found ourselves at 1.36%, almost 100 basis points (bps) lower than where we started the year. We then began a slow climb back to 1.8% before the election and we now find ourselves about 100 bps above the July low, with the likelihood of the first (and only) Fed hike for 2016 coming in December.
This was the sharpest sell off in fixed income assets since the 2013 “Taper Tantrum”. The recent volatility has many investors fleeing the asset class, as evidenced by the outflows from fixed income mutual funds and exchange-traded funds (ETFs). Estimates following the election indicated $9.06 billion flowed out of bond funds (the most in 3.5 years) and $25.38 billion flowed into equity funds (the most in 2 years). This is the largest disparity between fixed income and equity fund flows on record.
Source: U.S. Department of the Treasury
While almost everyone expects higher rates, the concern now for bondholders is the velocity of the recent move and impact on portfolio values. Below is a snapshot of fixed income performance.
Source: Barclays Live; YTD is 1/1/16-11/30/16
If you review the fundamentals, many factors supporting higher rates were already in place and now we’ve also removed the uncertainty surrounding the election. Consumer confidence has been improving and stands at the highest level since 2007; consumer spending has increased; oil prices are firming; global growth expectations are increasing; and inflation expectations are up sharply. The 10-year breakeven inflation rate has been increasing since the post crisis low reached in February (1.25%) and now stands at 1.95% (see chart below).
Source: Federal Reserve Bank of St. Louis; shaded areas indicate US recessions.
Global central banks have been targeting the creation of inflation and we continue to see inflationary pressures building here in the U.S. The Core Consumer Price Index (CPI), which excludes the most volatile components of food and energy already stands above the Fed’s target at 2.1% and has been above 2% since November 2015. If energy prices remain stable through February 2017, the energy component of Headline CPI, which includes food and energy, will post year over year gains resulting in an increase in Headline CPI of over 1.25%. As you may recall, the October reading was 1.6% (YoY) so this would put the broadest measure of U.S. inflation well ahead of the 2% Fed target.
Now, we also have the presumption that the Trump administration will cut taxes, ramp up spending on the military and infrastructure, and reduce regulations on businesses. That would be a formula for stronger growth, potentially benefiting stocks, but also higher inflation, which would have the Fed boosting interest rates faster than previously assumed, to the detriment of bonds.
The fixed income markets do not like surprises, but we believe the recent volatility should be viewed opportunistically not fearfully. We are seeing higher-grade bonds becoming a more viable income producing asset as yields are getting to levels that provide compensation above inflation expectations. This is important because inflation destroys purchasing power. If July 8th was the market top, this may indicate we are shifting to a prolonged rising rate environment. That would be your signal to review your portfolio and reassess if you are positioned properly for the current environment.
Our view is there are fixed income sectors with potentially attractive income generating opportunities and, in this environment, we prefer exposure to energy, financials, industrials, consumer discretionary and materials. In addition to sector diversification it’s likely critical to avoid long duration holdings. We believe long duration, interest rate sensitive fixed income assets are one of the riskiest places to invest, as even small moves up in yield will negatively impact portfolio value. Corporate bonds tend to outperform Treasuries when the economy is growing and interest rates are rising, and in this environment we would opt for Treasury Inflation Protected Securities (TIPS) instead of nominal Treasuries. We also continue to prefer lower investment grade corporate bonds for exposure to credit risk, as rates begin to normalize because they have less sensitivity to the interest rate cycle. We believe you should consider structuring portfolios in a defensive manner with higher than average coupons and a short duration. With expectations for higher rates on the horizon, this posture should benefit investors, potentially helping to reduce principal erosion while providing a higher level of income potential.
When we have uncertainty, remember hope is not a strategy and don’t let short term volatility prompt reactions that may not align with long term objectives.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.
CRN: 2016-1205-5669 R
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