Over the course of 2015 we recommended that investors carefully evaluate bond return expectations and bond holdings in their portfolios in light of the increasing likelihood that interest rates were bound to start drifting higher. Last month we highlighted the risk to bond returns in a rising interest rate environment.
Now, with the Fed having begun a new credit-tightening cycle, it is even more important that investors review the role of bonds in their portfolios. While we expect that throughout 2016 the Fed likely will maintain a very slow pace when it comes to raising interest rates, upward pressure remains probable on market yields across the fixed-income spectrum.
In an environment of rising interest rates (market yields), investors should consider moving to shorter-term, fixed-income investments for their bond allocations. As market yields rise, bond prices tend to decline, reducing total returns. In general, the shorter the time to maturity of a bond or note, the less sensitive the price will be to changes in market yields. So, if market yields are expected to rise, shorter-term maturity bonds will decline less in price relative to similar longer-term bonds.
As an example, Chart 4 shows the total annual returns for 10-year and 1-year Treasury securities. On the left side of the chart, prior to a 1981 peak in yields, the shorter-term 1-year bills tended to provide higher total returns, as indicated by the red line. On the right side of the chart, when yields were generally falling (and bond prices were trending higher), the longer-term 10-year Treasury notes tended to outperform.
One of our major themes in 2015 was the strong dollar and its impact on commodity prices. That theme continues as we enter 2016, especially in light of the Fed’s decision in December to raise interest rates. Relatively strong economic growth expectations in the U.S. compared with the rest of the world, combined with a central bank that has begun even a modest tightening cycle while many others remain extremely accommodative, is likely to drive the dollar even higher. A stronger dollar and weak global economic growth should continue to put downward pressure on most commodity prices.
The sharp drop in the price of crude oil has garnered plenty of attention and analysis over the past 18 months. We continue to highlight it because of its importance to the U.S. and global economies. This month we also focus on agricultural commodities because of their impact in specific areas of the U.S. economy. As already discussed, lower crude prices as well as declines in farm products such as corn, soybeans, and cattle are playing an important role in the performance of inflation gauges such as the CPI, and both have influenced capital investments for such things as buildings and machinery.
Our expectation is that these two trends (the rising dollar and generally lower commodity prices) are likely to be sustained for the next several months and possibly for several quarters (Chart 5).
One critical aspect of the research at AIER is the effort and determination to dig into the underlying forces driving the economy and capital markets. Real GDP, the CPI, and the Standard & Poor’s 500 Index of U.S. equities can all convey certain information: a summary, an overview, and aggregate perspective. But to truly understand the dynamics that are interacting—to identify the economic principles and theories at work—a good analysis will dig deeper. In the case of investing in equities, one way to do this is to look at the different sectors and industries within the broader market. This month we relate the macro forces of monetary policy (higher rates), global demand, and commodity prices to the performance of the industries affected.
The S&P 500 hit an all-time high in May 2015. For the year as a whole, the index finished about where it started, 2,043.94 on Dec. 31 compared with 2,058.90 as last year began, a decline of a little less than 1 percent. That was no doubt disappointing to many investors, but the weak performance masks widely divergent returns among the various sectors and industries. Shares of energy companies included in the S&P 500 fell by more than 23 percent last year. Agricultural products companies fared even worse, as their share prices dropped nearly 30 percent (Chart 6).
Eventually, fundamentals (sales, profit margins, and earnings) may stabilize and begin to grow at more desirable rates, and agricultural products and energy stock prices would anticipate and reflect the improving outlook. But for now, the combination of Fed tightening, the rising dollar, and weak global demand suggests these stocks may continue to struggle.
In the same way that sectors and industries in the U.S. perform very differently from the overall market, global equity sectors and industries can perform very differently from aggregate global markets.
We have already reviewed the forces depressing commodity prices in general and crude oil specifically. These forces are affecting energy companies around the globe. For global equities in aggregate, the economic forces driving prices are even more complex and diverse than the forces driving U.S. shares: economic weakness in Europe and Japan, a cooling expansion in China as the government tries to reconstitute the composition of economic growth, widely divergent central bank and fiscal policies, and heightened political tensions across the world.
Yet with all the greater complexity, the story for energy companies relative to the broader global equity market is similar: sharp underperformance (Chart 7). Economic trends typically don’t turn on a dime. Many of the forces suppressing energy prices are likely to continue for some time. At some point, these trends should reverse and energy prices should stabilize, but without a rebound in demand or some type of supply shock, it seems unlikely that energy prices will recapture the peaks of a few years ago for quite some time.