What’s Ahead for Fixed Income?

After more than thirty years of falling interest rates and thus rising bond prices, yields may be moving higher.  While trends are often short-lived, this new trajectory could persist into 2017 and beyond given recent changes in the political landscape as well as a less accommodative Federal Reserve (Fed).  We’ll take a look at what this new monetary and political environment may mean for bonds and how to best-position your fixed income portfolio for the long-term.

A proxy for the bond market, the 10-year Treasury note yield hit an historical low of 1.36% in July 2016 only to jump 100 basis points (or 1%) by the end of November.  The move came as investors responded favorably to the surprise U.S. Presidential and Congressional election results, in anticipation of higher growth levels in the years to come.

Part of the optimism stemmed from the new administration’s promise to cut consumer and corporate taxes and spend on infrastructure projects.  This picture presents a mixed bag for bonds, however.  Increased fiscal spending and lower taxes are positive for economic growth and a healthy economy is generally good for lending and credit activity.  But stronger economic growth would push yields higher and thus bond prices lower.  On the other hand, higher yields would provide investors with higher current income, acting as a partial offset to lower bond prices.  Rising interest rates or yields would also allow investors to reinvest into higher-yielding bonds.

Duration is an important characteristic to consider when reinvesting at higher yields.  A bond’s duration is the length of time it takes an investor to recoup his or her investment.  It also determines how much a bond’s price will fall when yields rise.  Longer duration bonds such as Treasury or corporate bonds with long maturities experience sharper price declines when yields rise.  Likewise, shorter duration bonds are less volatile and will exhibit smaller price declines, all else being equal.  Because we can’t predict the exact direction or speed of interest rate changes, it’s important to have exposure to bonds with a mix of durations.  In this way an investor is able to respond to any given environment.  For example, when yields are rising, an investor can sell her shorter-duration bonds, which are less susceptible to prices changes, and reinvest into longer-duration bonds with higher rates.

Another factor that affects bond prices is inflation.  Inflation expectations have started to heat up in light of low unemployment, wage growth, and expectations for increased government stimulus.  Higher inflation could also put upward pressure on interest rates and thus downward pressure on bond prices.  While inflation can erode the real returns of many bonds, some bonds, such as Treasury Inflation-Protected Securities (TIPS), stand to benefit.  TIPS are indexed to inflation and backed by the U.S. government.  Whenever inflation rises, the principal amount of TIPS gets adjusted higher.  This in turn leads to a higher interest payment because a TIPS coupon is calculated based on the principal amount.

Finally, the Federal Reserve’s shift away from accommodative monetary policy will have an impact on bond prices.  Although higher interest rates from the Fed will likely pressure fixed income prices, overall we view this change favorably.  This is because a return to more normal interest rate levels is critical to the functioning of large institutions like insurance companies and banks, which play a key role in our society.  Likewise, higher interest rates will provide more income to the millions of Baby Boomers starting to retire and would help stabilize struggling pension plans at many companies.

Taken altogether and in light of an uncertain environment, we believe a diversified bond portfolio targeted to meet your specific fixed income needs is the best way to weather this changing yield environment.  In addition to considering your specific income objectives, our Investment Policy Committee meets regularly to assess the current economic, fiscal, and monetary environment.  We adjust our asset allocation targets in order to take advantage of attractive opportunities or reduce exposure to higher-risk (over-valued) areas.  While we may over-weight some areas or under-weight others, in the long-run we continue to believe that a well-diversified portfolio is the best way to weather any market environment.

Thank you,

The Parsec Team

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Infrastructure Spending

The next driver of economic growth and company fundamentals?

Now that the U.S. presidential election is behind us and a big unknown has become known, stocks are responding favorably.  While equities are basking in a bit of short-term certainty following the November 8th election results, key questions remain.  One of the most significant relates to future government spending, and specifically, infrastructure.  After years of unprecedented monetary accommodation that may have artificially inflated equity prices, increased investments in our nation’s roads, bridges, and airports could provide a significant (and real) boost to corporate earnings and the economy.

Regardless of your presidential preference, both Clinton and Trump promised to increase infrastructure spending on the campaign trail.  Hillary planned to spend about $275 billion over five years while Donald claimed he would double her target.  Overall U.S. infrastructure recently received a grade of D+ from the American Society of Civil Engineers (ASCE), suggesting this is one instance in which competitive campaign rhetoric may work in our favor.

Most experts agree that the U.S. has underinvested in infrastructure for nearly three decades.  As a result, many of our bridges, roads, public buildings, and ports have not had significant upgrades in 50 to 100 years.  Government officials are well aware of the problem, but lack of bipartisanship has been a hurdle to distributing needed funds to critical projects.  While historically divided government has been more favorable for stocks, in this case, an all-Republican government may enable the passage of much needed infrastructure spending bills.

Research suggests that over the long-term, every $1 spent on infrastructure has the potential to boost economic activity by $3.  This is because updated roads, bridges, and buildings improve productivity and drive efficiencies.  Increased spending on these projects would also provide new jobs, further benefiting GDP growth.

While most focus on the economic gains, modernizing key infrastructure facilities may have the added benefit of reducing the harmful greenhouse gases that contribute to climate change.  According to a report by the Global Commission on the Economy and Climate, more than 60% of the world’s greenhouse gases are associated with old and ailing power plants, roads, buildings, and sanitation facilities, among others.

Finally, increased infrastructure spending may be the balm we need to escape from years of easy monetary policy that has inflated equity prices.  Stock valuations are trading above their long-term historical averages despite multiple quarters of weak sales and earnings growth.  Now with record-low interest rates poised to go higher and few tools left in the Federal Reserve’s tool box, a shift towards new fiscal policies that increase productivity and encourage corporations to invest – such as infrastructure spending – would provide companies with real sales and earnings drivers.  This in turn would help bridge the gap between currently lackluster fundamentals and elevated security prices.

To be sure, there are potential negatives associated with increased fiscal spending, including currently large labor shortages in the construction industry, dependence on prudent government spending, and regulatory red tape.  Likewise, increased infrastructure spending could add to an already elevated federal budget deficit.  However, taken altogether the positives appear to outweigh the negatives.  And new fiscal spending could be just what we need to keep the economy on track while supporting stock prices.

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Implications for “Brexit”

Investors received surprising news this morning, as the United Kingdom (U.K.) voted to leave the European Union (EU).  While markets will no doubt experience increased volatility in the coming weeks, longer-term, we believe the negative impact of “Brexit” will be largely contained to Great Britain and Europe.

Trade accounts for about 40% of the U.K.’s gross domestic product (GDP), with most of those exports and imports tied to EU partners.  As a result of the recent vote, Britain is likely to see higher trade tariffs from the EU and more trade staying within continental Europe’s borders.  Both of these shifts could weigh significantly on Britain’s economic growth in the mid-term and would likely weigh on EU growth as well.  One positive is that the U.K. never adopted the Euro, choosing instead to maintain the British Pound as its currency.  This is should make an exit from the EU smoother and slightly less costly than if they had converted to the Euro, and suggests it could be less detrimental than if Greece had left.

While the U.K. is likely to experience the largest negative impact by leaving the EU, continental Europe is also at risk given its relatively fragile economic expansion following the Financial Crisis of 2008-2009.  From 2010 through 2015, EU GDP has grown at an average rate of just 1.2% compared to U.K. GDP growth of 2.0%.  Thus any major shock, such as one of its strongest members leaving the Block, could derail those modest growth levels.

Turning to the U.S., Europe is one of our larger trade partners with about 16% of total U.S. exports going to the Block last year.  This is not an insignificant number, and will likely weigh on U.S. GDP growth in the near-term.  However, the U.S. consumer remains the largest driver of our economy, accounting for about two-thirds of GDP growth.  Following the Financial Crisis of 2008-2009, the U.S. consumer has gotten healthier, supported by an expanding housing market, strong jobs growth, and deleveraging.  A resilient consumer and relatively better economic growth compared to the rest of the world should position us to better weather the recent developments in Europe.

To be sure, today’s news surprised investors and markets alike.  Although the near-term economic impact will likely be limited to the U.K. and Europe, the vote has broader implications for the future of the European Union.  While we can’t predict the longer-term repercussions of today’s historical vote, we can assure you of the benefits of staying invested in a diversified portfolio over the long-term.  Markets will experience sharp corrections, as well as strong rallies, yet clients who remain invested across asset classes throughout the market cycle have a better chance of reaching their financial goals.  With this perspective in mind, market declines like the one we’re seeing today simply represent an excellent opportunity to rebalance your portfolio at more attractive valuations levels.

 

Thank you,

The Parsec Team

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Brexit: What is it and what are the investment implications?

There have been many headlines recently about the so-called “Brexit”, or the possibility of the United Kingdom leaving the European Union. There is a referendum on the subject coming up on June 23 in the UK, with current polls showing 47% in favor of staying and 40% in favor of leaving. This is not to be confused with the “Grexit” fears from a few years ago about the possibility of Greece leaving the European Union as well as the Euro currency. The UK is different in that it is a member of the EU, but continues to use the Pound as its currency rather than the Euro. Therefore, the UK maintains its own central bank and monetary policy. The main effect of such an exit has to do with trade agreements within the EU.

Potential negatives of an exit include a possible slowdown in the UK economy, short-term local stock market volatility and\or depreciation in the Pound. The EU represents about 50% of UK exports but only about 10% of imports, so if trade agreements are less favorable as a result of the exit then the UK stands to lose.

There are also positive factors to consider with regard to the UK. According to Goldman Sachs, the economy (as measured by Gross Domestic Product) in the UK is projected to grow faster than that of the US or the other Euro area countries in both 2016 and 2017. The Pound has already fallen 9% against the dollar over the past year, and the UK stock market has underperformed both the S&P 500 and the MSCI EAFE index over the same period. A vote to remain in the EU would remove the current uncertainty, and could be a catalyst for UK stocks to reverse their recent underperformance. If the vote is to leave the EU, many trade agreements will need to be renegotiated. This process will likely take years to complete, while UK stock market volatility should be short-lived.

To quantify our clients’ potential exposure to the UK, in a typical portfolio our target weighting for international stocks is about 26% of the overall allocation to equities. Of this amount, approximately 1/3 is emerging markets and about 2/3 developed markets. The UK is considered a developed market, and makes up about 20% of the MSCI EAFE index, which is the primary benchmark for most actively managed developed international mutual funds. This would imply that roughly 3-4% of our typical stock portfolio has exposure to UK equities through mutual funds, plus any additional exposure through individual stocks we might buy that are headquartered in the UK.

Since the outcome of the Brexit vote is impossible to predict with certainty, portfolio exposure to UK stocks is low and the effect of the vote on stock prices is indeterminate, we are maintaining our current target weights in international stocks.

From a diversification standpoint, investing in international stocks reduces overall portfolio risk since foreign stocks do not move exactly in tandem with US stocks. Sometimes international investing improves portfolio returns and sometimes it does not. In recent years international stocks have underperformed relative to the US, but historically there have also been periods of significant outperformance. While there will be more hype and headlines as the June 23 vote approaches, we remain committed to long-term investing in a globally diversified portfolio.

William S. Hansen, CFA
President
Chief Investment Officer

Bill

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32nd Annual Economic Crystal Ball Seminar

Each year we co-sponsor the Annual Economic Crystal Ball with UNC Asheville.  This is a great opportunity to hear Parsec’s Chief Economist, Dr. James F. Smith, and Nationwide’s VP and Chief Economist, Dr. David W. Berson, discuss the economic and financial outlook through 2017.  To register please email Kimberly Moore at kmoore@unca.edu or call at 828-251-6550.   A copy of the brochure can be found here.

  • Location: Lipinsky Hall Auditorium (Next to Ramsey Library)                                               UNC Asheville Campus
  • Date: Thursday, April 28, 2016
  • Reception: 6:15 p.m.
  • Economic Outlook:  7:00 p.m.
  • Financial Outlook: 7:30 p.m.
  • Q & A: 8:00 p.m.

The Economic Outlook will focus on inflation, employment, interest rates, the strength of the dollar and the housing market. The Financial Outlook will explore the implications of Federal Reserve policy for the financial markets. Various investments will be addressed, with an emphasis on interest rates and the bond market.

About our Speakers

David W. Berson, Ph.D                                                                                                              Dr. Berson is Senior Vice President and Chief Economist at Nationwide Insurance, where his responsibilities involve leading a team of economist that act as internal consultants to the company’s business units.  His numerous professional experiences include Vice President and Chief Economist at Fannie Mae from 1989-2007, past president of the National Association of Business Economists, and senior management position with Wharton Econometrics Forecasting.

James F. Smith, Ph.D.                                                                                                              Dr. Smith is the chief economist at Parsec Financial.  He has more than 30 years of experience as an economic forecaster. Dr. Smith’s career spans private industry, government and academic institutions, and includes tenures with Wharton Econometrics, Union Carbide, the Federal Reserve and the President’s Council of Economic Advisers.

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