3/30/2021: Market Update by Jack Ablin, Chief Investment Officer at Cresset
Thanks to a rush of vaccines, COVID-19 infection rates are plunging. Confirmed cases in the US are running at an average daily rate of about 53,000, half the rate of last month. Talk of reopening is welcome news to a nation of lockdown-weary consumers, many of whom are sitting on a stockpile of savings. The $1.9 trillion relief package passed earlier this month, added to last December’s $900 billion stimulus and a potential $3 trillion infrastructure program, has economists tripping over themselves to ratchet up their US growth forecasts. The US economy is expected to expand at an annualized rate of nearly 7 per cent quarter over quarter in Q2 and Q3 of 2021, according to a Bloomberg survey of private economists. That would represent the strongest back-to-back quarterly expansion since 1983.
Investors, armed with the bright forecast, have been hitting the sell button on bonds. The yield of the benchmark, 10-year Treasury has climbed to 1.7 per cent from as little as 0.5 per cent last August. The yield rally pushed longer-maturity Treasury prices down between 13 per cent and 20 per cent for the year. Notwithstanding the yield rally, today’s 1.7 per cent is still too low by historical standards when gauged against the economy. Historically, the 10-year Treasury yield tracked nominal GDP growth (real growth plus inflation) before the Fed intervened with quantitative easing. Economists are currently forecasting nearly 10 per cent nominal GDP growth for Q2 and 9.5 per cent for Q3, with growth trending toward 5 per cent by the middle of 2022. That’s a far cry from 1.7 per cent, considering the magnitude of Treasury supply and the tendency for the Fed to back away from quantitative easing, a program they view as an emergency measure.
Yields this low impair bonds’ ability to hedge equity risk, undermining the philosophical underpinnings of the 60/40 portfolio mix. That’s because low yields have attenuated bonds’ ability to cushion an equity hiccup. At 1.7 per cent, the best return available to investors in the US Treasury 10-year note is about 17 per cent, assuming yields plunge to zero by this time next month. Moreover, the largest component of the equity markets’ return over the last 10 years has been derived from the interest rate slide since the financial crisis, as lower benchmark rates support higher price-earnings ratios. Over the last 10 years, 286 percentage points of the Russell 1000 Growth Index’s 389 percentage-point return can be attributed to valuation expansion. Bond and stock price correlations are converging as large cap growth stocks fall against a backdrop of rising yields.
Notwithstanding the strained market environment for fixed-income securities, bonds offer investors cashflow certainty – an attractive, albeit expensive, attribute in an uncertain world. The predictability of cash flow is an indispensable feature that requires investors to continue to hold bonds in a goals-based investing framework. Goals-based investing aligns clients’ assets to meet specific lifestyle cashflow needs from now through the next 40 years or more. While equities can satisfy cashflow needs beyond seven years, they are too volatile to have enough statistical confidence to address cashflow needs inside of seven years. That’s where a laddered portfolio of bonds can be constructed to assure the income to fund nearer-term spending. History has shown that it takes roughly seven years for a portfolio of stocks to attain a 99 per cent chance of achieving a positive return, while it takes a portfolio of bonds only three years to attain a 99 per cent chance of achieving a positive return. High-quality, individual bonds held to maturity can deliver a positive, albeit low, return in months.
We believe higher yields and inflation will threaten the investment landscape for the next year or two. After that, we believe longer-term forces, like aging demographics and technological innovations, will take a leading role in stemming price acceleration. Eventually, we expect yields to move high enough for bonds to once again become an attractive hedge to a diversified equity portfolio. Until that happens, bonds are an expensive luxury that offers investors cashflow certainty – a valuable attribute in today’s uncertain world.
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