The End of Risk-Free Returns


Jefferson V. DeAngelis

Jefferson V. DeAngelis

The End of Risk-Free Returns

March 30, 2018

Markets are known for offering investors lessons in humility. On the one hand, Warren Buffet suggests that “humility can make you rich.” On the other hand, a lack of humility, typified by chasing unsupportable gains (aka Bernie Madoff), can lead to ruin. The difference in outcomes rests on the ability of investors to gauge the market. While not writing about financial markets, author David Richo sums it up best, that “humility means accepting reality with no attempt to outsmart it.” Accordingly, investors must recognize that the market reality of the last several years may soon be ending.

Over the last several years, a recovery in corporate revenues and earnings resulting from a pickup in global growth have fueled the rapid advance in equity prices globally. Finally, after close to a decade of economic subpar performance, global economies are getting into synch. Ironically, it is the realization of the uptick in growth that set the stage for the first significant correction in equity prices since the U.S. election.

Rising risks of inflation typically accompany late cycle expansions. Central banks tend to become more restrictive forcing the front end of interest rates up. The magnitude of central bank intervention in markets and unconventional accommodation make this market cycle unique. By forcing long-term interest rates down and removing $12 trillion of high-quality assets from the markets, central bankers encouraged massive speculation, which has stretched asset class valuations. As a result, markets are more vulnerable to shifts in sentiment related to rising rates and inflation. The leverage in the system will restrict attempts to normalize rates. Higher levels of volatility reflect that risk.

Market tops are, by definition, the point of maximum optimism. The enactment of the Trump tax cuts proved to be the catalyst for a normal 10% correction in stock prices. Most of the positive aspects of the plan had been discounted by the impressive performance of risk assets in 2017. The market shifted its focus to the fiscal gap left by the tax cuts.

The synchronized global growth story is what the markets have been discounting. The realization that growth could be paired with rising rates and inflation was dismissed as non-impactful. The mistake was to ignore the role that low interest rates, low inflation and debt creation have played in determining today’s asset valuations. Momentum and low volatility were more responsible for the run-up in global equities early in 2018 than fundamentals. This past February proved to be a turning point.

The period of historically low volatility following the U.S. elections was an aberration. Volatility is not an asset class to be traded but a measure of risk that should be commensurate with returns. Returns without risk should have been one of Mahatma Gandhi’s seven deadly sins like wealth without work, science without humanity and politics without principles.

As usual, we have a gradual slowing in global economic activity during the first quarter of the year. Eventually, economists will learn to adjust to this seasonal pattern. The underlying momentum, however, does appear to be able to carry us through 2018 without a significant chance of recession. Central banks will continue to tighten monetary policy at a gradual rate. Problems are unlikely to appear until 2019 and could be discounted by risk markets later this year.

The wildcard is still interest rates. A spike in interest rates and a steeper curve could short-circuit the economic cycle. This seems very unlikely given market participants are positioned for rising interest rates. Rates have risen smartly since year-end, and the yield curve has steepened slightly. We would expect the 10-year Treasury to find support just behind 3.0% with most of the interest rate risk in the front end of the curve. The curve should resume its flattening trend.

We anticipate that the end of the tightening cycle will not reach 3% on the fed funds rate and may only reach 2.5% this cycle. With the 2-year Treasury at 2.2%, there is not much room for rates to move much higher despite extreme negative sentiment on bonds. We see more risks for equities as dividend yields have fallen below 2-year Treasury notes. Crowded trades often are where the risks are. Investors are currently overweight equities relative to bonds and chasing late cycle returns.

What could go wrong?


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2018-05-04T09:50:48+00:00 By |