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September 28, 2018: Swimming Naked

“You never know who’s swimming naked until the tide goes out.”
- Warren Buffett

As expected, on Wednesday the Federal Reserve raised its target for short-term interest rates for the third time this year and the eighth time since it began its rate-hike campaign in December of 2015 following seven years of near-0% short-term rates. Wednesday’s move brings the Fed’s target for short-term rates to between 2% and 2.25%. Assuming the U.S. economy’s current strength continues, the Fed expects to raise its interest rate target another percentage point over the next year or so.

As a reminder, increases in the Fed’s short-term interest rate target translate into higher yields on money markets and short-term bonds. Currently, money markets and high-quality short-term bonds are paying 2-3%, and their yields should continue to rise in the coming months assuming the economy remains strong and the Fed continues to raise rates. After nearly a decade of enduring 0-1% yields on money markets and high-quality short-term bonds, this is a very positive development for risk-conscious investors.

Swimming Naked

We acknowledge recycling many of Warren Buffett’s quotes in our newsletters, but his quote regarding swimming naked seems apt to us at this point in the economic and investment cycle. Buffett was analogizing swimming naked to investors taking risks that will be revealed in an unpleasant way when economic conditions change.

By keeping interest rates artificially low for so long in this economic expansion, the Fed forced investors to choose between accepting low returns on safe investments versus reaching for higher returns by taking more risk. Many investors adopted the latter strategy, feeling they had to abandon their risk aversion and move out on the risk spectrum in order to earn acceptable returns. Given that the prices of riskier investments such as stocks and lower quality bonds have not fluctuated much during this expansion, more aggressive investors have effectively earned something (higher returns) for nothing (not much additional risk).

We are not in the prognostication business, so we will not attempt to predict the timing of the end of this economic expansion. Despite it being the second-longest expansion in history, it certainly feels like it could continue for a while.
Taking the temperature of consumers and investors, however, leads us to conclude that it is not a time for complacency. Consumer confidence tends to increase as economic cycles mature, and current measures of consumer confidence are the highest they have been in 18 years. Growing confidence tends to lead to weaker vigilance on the part of investors, and many investors currently have more risk in their portfolios than they may realize. Importantly, high levels of consumer confidence and investors’ allocations to riskier investments have proven to be contrary indicators in the past, preceding economic recessions and investment declines.

We concede that it takes fortitude to embrace a risk-conscious approach when markets are rewarding aggressive behavior, but we think it is unwise to become more aggressive at this time. Our biggest investment concern at this point is the growing level and declining credit quality of corporate and government debt. We have welcomed the rise in money market and Treasury yields and have spent much of this year improving the credit quality of our bond holdings. We feel owning these will provide you with a suitable pair of swim trunks when economic conditions change and the tide goes out.

Past performance does not guarantee future results. Investment strategies discussed may not be suitable for all investors. Diversification does not guarantee against investment loss. The information provided here is for general informational purposes only. The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation. Investors should thoroughly evaluate any security before taking action. International investments involve special risks, including currency fluctuations and political and economic instability. Opinions expressed are subject to change without notice in reaction to shifting market conditions. Data contained herein is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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August 1, 2018: Recession Signal?

“Most things I worry about…never happen anyway.”
- Tom Petty, from Crawling Back to You

The financial press has recently been consumed with the near-term potential for an “inverted yield curve.” This describes a situation in which shorter-term interest rates exceed longer-term interest rates. As of this writing, the yields available on 6-month and 2-year Treasurys, which are commonly used as measures of short-term interest rates, are 2.27% and 2.67%, respectively. The yield on the 10-year Treasury, which is commonly used as a measure of longer-term interest rates, is 2.98%.

Many people are confused by the relationship between the Federal Reserve’s interest rate policies and the level of interest rates on various types of bond investments (and loans). Shorter-term interest rates are overwhelmingly determined by the Federal Reserve’s actions; this is why yields on 6-month and 2-year Treasurys have risen by approximately 2% since the Fed began raising its target for interest rates in late-2015 and are the highest they have been in ten years.

Longer-term rates, on the other hand, are generally driven by investors’ expectations for longer-term economic growth and inflation, and may or may not follow changes in shorter-term rates. The 10-year Treasury yield of 2.98% is higher than it was when the Fed began raising its interest rate target in late-2015, but it has not risen nearly as much as yields on shorter-term bonds. Thus, the spread between short-term and long-term interest rates has narrowed; this is referred to as a “flattening yield curve.” If long-term rates remain where they are and the Fed continues to drive short-term rates higher, we will experience an “inverted yield curve” whereby short-term rates are higher than long-term rates.

Who Cares?

Historically, an inverted yield curve has been an excellent predictor of economic recessions. According to The Wall Street Journal, “Over the last 50 years, a recession has followed every time the yield on two-year Treasurys has exceeded that of 10-year Treasurys.” Although the 2-year Treasury yield is still lower than the 10-year Treasury yield, one or two more interest rate increases by the Fed may do the trick. Given how close we are to an inverted yield curve, you are likely to hear more about this subject in the coming months.

As you might imagine, it is difficult to use the yield curve as a means to predict the specific timing of a recession and/or to adjust your investment portfolio’s targeted stock allocation to reduce your risk. The yield curve last inverted in December of 2005, but the Great Recession did not start until December of 2007. In earlier instances of an inverted yield curve, the timing and severity of recessions and stock market corrections varied considerably.

Another problem with analyzing today’s yield curve is attempting to quantify how much the current low level of long-term interest rates reflects global central banks’ generous monetary policies (e.g., purchase of longer-term bonds) versus investors’ concerns over future economic growth. As The Economist recently observed, “just how much distortion [to the yield curve] is occurring is unclear concerning the effect of asset-purchase programs by the European Central Bank and the Bank of Japan.”

The 10-year Treasury yield of 2.98% looks downright juicy compared to the barely-visible yields on many European and Japanese government bonds. This condition may continue to keep a lid on longer-term U.S. Treasury yields for the time being and may or may not reflect an impending economic slowdown.

What to Do?

We are respectful of the yield curve’s signals and mindful that the current economic expansion in the U.S. is the second-longest in modern history and cannot continue forever. We do not believe this is a time for you to take on more risk. Having said that, we do not necessarily believe an economic recession is imminent in the U.S.

Perhaps most importantly, we are pleased that we can finally earn a return on safe investments such as money markets and Treasury bonds and, as a result, we have made changes to the bond portion of many of our clients’ portfolios in recent months. Specifically, we have been gradually replacing a portion of non-Treasury bonds with Treasurys and money markets and expect to continue to do so in the coming months. These have tended to provide the greatest protection from recessions and stock market corrections in the past and we expect they will continue to do so in the future.

Past performance does not guarantee future results. Investment strategies discussed may not be suitable for all investors. Diversification does not guarantee against investment loss. The information provided here is for general informational purposes only. The inclusion of specific securities within the context of broad economic commentary is not intended to be a recommendation. Investors should thoroughly evaluate any security before taking action. International investments involve special risks, including currency fluctuations and political and economic instability. Opinions expressed are subject to change without notice in reaction to shifting market conditions. Data contained herein is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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