Published on May 1, 2018
Volatility Makes an Appearance in the First Quarter
The return of volatility took investors on a wild ride during the first quarter of the year. While the overall trend for market yields is higher, several factors complicated the picture this quarter, resulting in market gyrations that kept investors on their toes. We believe historical relationships and trends that have characterized the last several years are beginning to fray, suggesting to us that markets have reached an inflection point. Pattern changes that point to this include unusual changes in credit spreads and the shape of the yield curve, as well as the correlation between stock and bond prices relative to economic activity.
While the past several years have been characterized by accommodative monetary policy, a low-growth economic recovery, and very slight inflation, leading to a persistent flattening of the yield curve and tight spreads, an abrupt reversal occurred mid-February, sparked by labor market data which triggered inflation fears and concern this could prompt the Federal Reserve to accelerate their plans. In March, these concerns abated, and were sidelined by fears of a potential trade war, which sparked volatility in the stock market and precipitated a “flight to safety” in Treasury bonds, driving yields lower. Despite the 10 Year Treasury spiking to a four-year high of 2.95% in February, the yield curve’s overall trend for the quarter was continued flattening.
We view the shape of the yield curve as noteworthy relative to the past five years. The difference between the US Treasury 2-year and 10-year notes has compressed throughout the economic recovery from the financial crisis, ranging from a modest 0.50% to over 2.50%. Interest rates on both short- and long-term US bonds have been rising as the Fed continues its slow and steady approach toward a more normalized rate environment. However, the ascent is following a bear flattening approach, whereby short-term rates are rising faster than long-term rates. While this may prompt questions on whether an inverted yield curve may be on the horizon, this phenomenon is traditionally short-lived and occurs when recessionary pressures are far more pervasive than what we are seeing right now.
We believe corporate credit markets may be beginning to separate and move in more independent directions. Yield spreads between investment grade corporate bonds and the US Treasury 10-year note had been narrowing steadily for nearly two years, yet this yield spread reached historical narrow levels during the first part of the quarter then reversed dramatically, returning to the yield spreads of mid-2017. Over the quarter, spreads between US Treasury and US corporate issues tightened, widened, and then tightened again. Going forward, we anticipate greater potential for widening.
Based on these observations, our thought is that after many years of bond and equity price changes being tied closely together, the strength of this relationship may be starting to weaken. Instead of bond prices rising and yields declining in tandem with economic good tidings, bond prices may begin to decline while yields rise, independent of equity market fortunes. There are significant trends to consider in support of this inflection point: tightening monetary policy remains in place for further rate hikes, loosening fiscal policy seems likely following plans to expand the Federal deficit, and the yield spreads necessary to compensate lenders for the risks of non-government-guaranteed issues may be expanding.
These new pressures are already presenting challenges in terms of relative performance between US credit market sectors, as demonstrated in the wide range of total returns across sectors for the first quarter. While the ICE BofAML 1-10 US Treasury and Agency Index returned -0.69%, the ICE BofAML 1-10 US Corporate Index returned -1.46%, and the ICE BofAML Fixed Rate Preferred Securities Index returned -1.00%.
The Roosevelt Current Income Portfolio (“CIP”) remains focused on providing the highest possible current income investment characteristics while assuming the least amount of risks. While total rates of return (over longer investment periods) remain an important measurement of wealth creation, and a cornerstone of our underlying process and strategic decision-making, the CIP strategy is focused primarily on maximizing current income through a reliance on a relatively patient and conservative approach.
At the end of 2017, we reduced the portfolio’s overall duration (interest rate risk) as well as its allocation to preferred stocks, while shifting the allocation towards fixed-to-floating rate preferred structures. These adjustments helped to moderate a slightly negative total rate of return over the quarter. Equally important, the portfolio is strategically designed to preserve its ability to take advantage of rising rate environments as they become available. A slow drift higher in nominal US interest rates as changes in expectations for inflation and monetary policy manifest remains the most reasonable expectation, in our view. How the markets respond remains fluid, of course, but we continue to maintain our view of greater downside price risks than upside potential, and are conservatively positioned as a result.