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

Share this:

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.

Share this:

Market Update Through 06/30/2016

as of June 30, 2016
Total Return
Index 12 months YTD QTD June
Stocks
Russell 3000 2.14% 3.62% 2.63% 0.21%
S&P 500 3.99% 3.84% 2.46% 0.26%
DJ Industrial Average 4.50% 4.31% 2.07% 0.95%
Nasdaq Composite -1.68% -2.66% -0.23% -2.06%
Russell 2000 -6.73% 2.22% 3.79% -0.06%
MSCI EAFE Index -10.16% -4.42% -1.46% -3.36%
MSCI Emerging Markets -12.05% 6.41% 0.66% 4.00%
Bonds
Barclays US Aggregate 6.00% 5.31% 2.21% 1.80%
Barclays Intermediate US Gov/Credit 4.33% 4.07% 1.59% 1.43%
Barclays Municipal 7.65% 4.33% 2.61% 1.59%
Current Prior QTR
Commodity/Currency Level Level
Crude Oil $48.33 $38.34
Natural Gas $2.92 $1.96
Gold $1,320.60 $1,235.60
Euro $1.1110 $1.1396
Share this: