Q2 2018: PFM Quarterly Commentary
While observing the investment markets’ behavior during 2018’s second quarter, we couldn’t help but be reminded of the near identical script that played out during the summer of 2013. As a reminder, 2013 showcased several market anomalies caused by abrupt changes in monetary policy, including historically large return dispersions between correlated assets and jarring movements in interest rate and currency markets. Said more simply, markets just didn’t act like they were supposed to.
While not of the same scale as five years ago, the second quarter showcased stark outperformance by large cap U.S. stocks compared to their international counterparts. The S&P 500 recovered much of the swoon it suffered earlier in the year by returning 3.4% for the three month period ending June 30th. International large cap stocks, on the other hand, fell 0.9% for the same period while emerging market equities continued their challenging year by losing 7.8%. Like 2013, bonds, particularly international fixed income securities, declined steeply. As a point of reference, the Bloomberg Barclays Global Aggregate Bond Index fell 2.8% this quarter alone.
Stepping back, we saw investors respond similarly to recent changes in monetary policy as witnessed in 2013. Five years ago, on May 22nd, the Federal Reserve announced that it would start tapering its unprecedented monthly stimulus program, marking the unofficial end of emergency monetary measures implemented during the Great Recession. Naturally, market participants viewed this change in policy by the Federal Reserve, from historically dovish to uncharacteristically hawkish, as alarming. Over the course of that summer, investors aggressively sold fixed income, causing the yield on the ten year U.S. Treasury bond to nearly double from 1.58% to 3.01% in just four months. Surging bond yields triggered a rally in the U.S. Dollar, which rose nearly 7% by mid-summer.
This volatile period in 2013 became famously known as the “Taper Tantrum”. The rapid change in investor expectations regarding future monetary policy paired with a rise in interest rates and the appreciation of the U.S. Dollar, sent much of the investment world into disarray. In 2013, the S&P 500 outpaced international stocks, emerging markets, and domestic bonds by 9%, 34%, and 35%, respectively. Likewise, other yield sensitive securities such as real estate, mortgage REITs, and Master Limited Partnerships (MLPs) underperformed the S&P 500 just as dramatically.
Fast forward to the present where we witnessed a similar hawkish approach from the Federal Reserve and a nearly identical investor response. During the second quarter the Federal Reserve increased interest rates, but also expanded its monthly Quantitative Tightening program (we covered this extensively in last quarter’s publication). To recap, Quantitative Tightening is the process by which the Federal Reserve removes liquidity from the monetary system by selling bonds from its $4.45 trillion balance sheet. The first quarter of 2018 saw the Fed siphon $52 billion of liquidity while the second quarter tightening totaled $87 billion.
Like 2013, investors reacted to the monetary tightening by aggressively selling bonds, which in turn sharply increased interest rates and drove the U.S. Dollar higher by roughly 8%. As detailed above, the Fed’s actions again sent shockwaves through both international equity and bond markets. Emerging markets were hit especially hard.
However, in the last several weeks we have observed some key differences distinguishing this recent period from 2013, leading us to believe the Fed may have gotten ahead of itself. Most evident was that long term interest rates fell over the last six weeks of the quarter, with the decline accelerating after June 21st when the Federal Reserve raised interest rates. Also, yield sensitive sectors, which suffered greatly in the same environment during the first quarter, soared in Q2. Real estate, mortgage REITs, and Master Limited Partnerships (MLPs) returned 8.9%, 5.7%, and 12.9%, respectively, in the second quarter compared to a 3.4% return for the S&P 500. Sectors such as Financials and Industrials, which should have outperformed given the Fed’s upbeat assessment of the economy, underperformed the S&P 500 by both falling 3.2% for the quarter.
Perhaps most critical is that the Federal Reserve raised short term interest rates, but long term interest rates didn’t rise accordingly, bringing the entire yield curve close to inverting. In layman’s terms, an inverted yield curve signals to investors that real economic growth is stalling. Every instance in modern history of an inverted yield curve has portended a recession with the exception of one occasion in the 1960s where growth slowed significantly, only narrowly missing the technical definition of a recession.
The head of the Federal Reserve, Jerome Powell, knows the importance of not inverting the yield curve and has vowed to prevent it. The problem is that he also declared that the Fed will raise interest rates two more times in 2018, presumably adding another .50% to the short end of the yield curve. This action would put the yield curve dangerously close to an inversion; clearly, the Fed doesn’t have much room to carry out its plan should long term rates remain near current levels.
The strong performance during the second quarter by yield sensitive securities lends credence to the idea that investors are wagering that the Fed may be forced to stop raising interest rates in an effort to accelerate inflation and put upward pressure on long term interest rates. This theory is supported by the performance of certain S&P 500 sectors since the hawkish Fed meeting on June 21st. Given the Fed’s robust appraisal of the economy, growth sectors such as Technology, Financials, and Consumer Discretionary should have outperformed. However, since that meeting those sectors fell 2.6%, 2.4%, and 2.0%, respectively. Over that same time period, defensive sectors such as Utilities and Telecommunications outperformed, rising 3.1% and 2.4%, respectively.
For much of 2018, Peak held the belief that markets would ultimately discourage the Fed from pursuing its aggressive tightening program. For the first quarter much of the world seemed to disagree with the firm’s prediction, as our yield sensitive tilt fell out of favor. However, the second quarter showed that much of the investment community had started to adopt our outlook. The result was that a number of Peak’s lagging securities outperformed during the quarter. For Q2, the best performing asset classes in Peak’s portfolios were Master Limited Pipelines (MLPs), real estate, commodities, and mortgage REITs, returning 12.9%, 8.9%, 6.2%, and 5.7%, respectively. Additionally, Peak’s overweight to domestic equities also benefited the portfolios with investments in broad equities, large cap stocks, materials, and healthcare, returning 3.9%, 3.6%, 2.7%, and 1.8%, respectively.
As mentioned earlier, international markets, particularly emerging markets, underperformed relative to those in the U.S. The result was that Peak’s holdings in emerging market stocks, international high yield bonds, and broad international large cap stocks fell 9.6%, 3.3%, and 2.0%, respectively. The sharp rise in the U.S. Dollar added insult to injury, acting as a headwind to not only international stocks and bonds, but also to precious metals (whose prices typically move inversely to the U.S. Dollar), resulting in a 4.3% decline for the quarter.
In summary, while the second quarter drew many parallels to the “Taper Tantrum” of 2013, there were some important differences which support our belief that the Fed will be forced to curtail its tightening measures this year. Should that occur, we expect both domestic and international equities to benefit. Either way, it will be intriguing to see how the Fed reacts to this year’s rapidly evolving economic environment.
As always, please do not hesitate to contact the Peak team with any questions. Enjoy your summer, and we look forward to speaking with you soon.
Regards,
Peak has created a monthly “quilt” of returns to track the performance of the major areas of the investment markets over time. We believe that this table best illustrates the fundamental tenets of Peak’s investment philosophy, namely the futility of predicting which investments will outperform over the short term and the unremitting cyclicality of markets. These truths support our firm belief that broad based diversification over many areas of the world economy is the best path to investment success over the long term. Asset Class Quilt of Total Returns – June 2018
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This presentation may not be construed as investment advice and does not give investment recommendations.
Presentation of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
Additional information, including management fees and expenses, is provided on Peak Financial Management, Inc.’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Peak does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.