Month: February 2018

Recent Market Volatility: Four Key Questions Answered

Posted on by Sage Advisory

On Monday, February 5th the US equity market experienced its first 5% drawdown in 405 days. Three days later equities reached a 10% drawdown, which hadn’t occurred in almost two years. Market participants are now processing this move in real-time. Experts stand on both sides of the spectrum – some calling for a further correction, while others advise to “buy the dip” as the move this week is being deemed to be detached from fundamentals.

So why is this happening? In our view, there is no single cause, but a confluence of circumstances and events. Crowded positioning and bullish sentiment laid the groundwork. And, while economic growth and corporate fundamentals are strong, valuations fully reflect the underlying positive conditions. Here are the key events over the past two weeks that have stirred up market volatility:

  • Bond yields rose after the US Treasury announced increased bond issuance on January 31st in response to a larger budget deficit. In addition, the current administration’s announced plans for increased defense and infrastructure spending are expected to result in even more Treasuries issuance.
  • Wage data released last week surprised to the upside giving rise to fears of an overheating economy in which inflationary pressures may drive central banks to tighten financial conditions further and slow the current growth cycle.
  • On February 5th, the VIX index spiked 20 points which is the sharpest rise ever for the index. Many investors, especially those with strategies linked to volatility, were caught off-sides and rushed to de-risk which exacerbated the correction throughout the week.

So what now? While we think technical selling ultimately subsides in the near-term, we believe that a period of higher volatility is here to stay. Below, we address the four most important questions for macro investors looking forward.

  • Growth: How is the economy doing? Amid this month’s turmoil, economic data and corporate earnings continue to surprise to the upside. Tax reform should provide a boost to the corporate sector and consumption. The synchronous global growth conditions haven’t changed.
  • Policy: Are central banks tightening or easing conditions? Central banks have taken notice of the strong economy, and have increasingly adopted a tighter stance as conditions have improved. However, we do think that concerns around financial stability and increased Treasury issuance provide a counterbalance to central bank tightening. We have not yet seen a desire for policymakers to respond to recent market developments. It goes without saying that an exit from global QE will be tricky. No matter your age, no one has experienced an exit from QE of this scale.
  • Valuation: What is the market’s pricing of economic conditions? Given growth conditions and policy expectations, we think valuations are key. Global equity valuations fully reflected the positive side of strong growth and a healthy corporate sector. The markets are now adjusting to the reality of balancing the downside of strong growth and the end of QE. The rates market has priced in three rate hikes for 2018, and nearly two for 2019. The market is fully expecting the Fed to reach its rate targets.
  • Sentiment: What is the prevailing market psychology? Market participants were euphoric in January, and after the recent move, sentiment has reverted to a normal level. January saw the largest inflows ever into equity ETFs (+$62 billion) and February is now seeing the largest equity ETF outflow on record ($30+ billion). The American Association of Individual Investors survey signaled extremely bullish sentiment in January. This week’s report showed a drop in sentiment back to more normal levels.

Undoubtedly, we know this year will not be like the last, where virtually all markets moved higher with little volatility. We’ll continue to assess the macro developments through our framework of Growth, Policy, Valuation, and Sentiment. This framework should serve our clients well in navigating the volatility ahead.

 

Source: Bloomberg. This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Speaking of Interest Rates

Posted on by Sage Advisory

When you live the life of a fixed income manager, it’s rare that a day passes without someone asking the question, “what do you think about rates?”. Rather than answer, our response typically includes our own questions that go something like this, “what rates are you referring to and where along the yield curve?”. While the Fed has a meaningful influence on short term rates, supply & demand forces cause mid & long-term rates to shift every day. Economic growth, inflation, risk appetite, and broader global monetary policy all play roles in moving rate markets. And, while the global bond market is certainly interconnected, the different fixed income market segments – Treasuries, IG Credit, High Yield, Non-Dollar, etc – will zig and zag based on fundamentals, valuations, and sentiment.

Scary headlines about how rising rates are going to devastate fixed income allocations provides a welcome opportunity to hit on some fundamental truths about fixed income:

  • A ‘bad hair day’ for core fixed income is different than a ‘bad hair day’ for stocks. Yes, a big move higher in long Treasuries will hurt if your’ portfolio consists of 100% long Treasuries. Properly diversified fixed income allocations typically weather rate volatility just fine.
  • As fixed income investors, we want rates to rise. We just want it to happen slowly and for policy changes by the Fed to be well telegraphed. But, like the Rolling Stones said, you can’t always get what you want. The key for fixed income investors is to stay diversified, stay within policy, and most importantly know what you own.
  • In addition to the well documented diversification benefits, nothing replaces the utility function of fixed income. For clients who have a known liability, cash flow, or purpose for their investment portfolio, a properly structured fixed income allocation can address the utility with a high degree of certainty and relative safety.

So are higher rates a good thing? They certainly have been for cash investors, though it’s unclear how many people are paying attention. Following the 2016 regime change in Washington, short-term interest rates jumped substantially. The 2-Year US Treasury Note increased from 1.20% to 2.16% over the last 13 months (as of 1/31/18). To put that move into context, the 10-Year Treasury traded through 2.16% this time last year. Today, a typical Government Money Market Fund yield is close to 0.80%, a typical Prime Money Market Fund yields around 1.10%, and the custom Cash Management SMA Sage manages yields approximately 2.20%. Not only does this give institutions the opportunity to earn more on their cash, they also have differentiated investment options to consider. We recently published a white paper on the topic of Cash Management if you want a bit more fixed income nerdiness in your life.

Source: Bloomberg, Morningstar Direct. This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.