Market Outlook
Treasurys, investment-grade credit, and gold were the worst-performing sectors in February. The Merrill Lynch 10yr Treasury Futures Total Return Index returned -2.36% in February and -3.10% year-to-date. A 30-year U.S. Treasury Bond with a 1.25% coupon maturing 05/15/2050 closed Friday at $80, wiping out nearly 17-years of coupon payments for someone who owned the paper last August at $101.56 (h/t to John Mousseau of Cumberland Advisors). We believe U.S. Treasury debt is starting to look like distressed emerging market debt.
Global bond yields are marching higher. Since last September, the U.S. 10-year yield rose 72 basis points from 0.68% to 1.40%.
The factors driving bond yields higher differ by country. Countries in a reflationary regime (accelerating growth and inflation expectations) like the U.S., U.K., and Australia have experienced the sharpest move in bond yields. Rising inflation expectations account for more than 100% of the modest bond yield moves in Germany and Japan, inferring a stagflation regime for those two major exporting economies. Conversely, France's economic momentum accounts for more than 100% of that country's move in bond yields as inflation expectations fall (restart regime).
Bond vigilantes appeared last week, pushing the U.S. 10-year yields from 1.45% to above 1.60% in a single hour of trading. Long absent from this QE-driven market, bond vigilantes protest monetary and fiscal policies considered to be inflationary by selling bonds. They are bond bears who push back on the Fed's narrative machine that attempts to convince market participants that everything is under control.
The Fed's well-known dot plot is their method for conveying the interest rate outlook to the markets. The Fed is signaling it will keep policy rates unchanged at 0% beyond 2023. One need only look to the Fed Funds or OIS futures to see the market expects at least one rate hike next year and a second in 2023. Bond vigilantes do not believe the Fed’s dots. Neither does RiskBridge.
Liquidity Cycle
The global money supply is growing 8% at a 6-month rate of change. The top six global central banks' cumulative assets have expanded 1%, led by the Fed (+3%) and the Bank of England (+7%). US liquidity is growing at +24% y/y driven by M2 money supply (+26% y/y), commercial lending (+9.3%) and trade (+12% net imports). The U.S. Treasury aims to reduce its cash balance from $1.6 trillion to $800 billion by the end of March. This technical action will help finance federal spending and may pave the way for the Fed to expand its balance sheet further.
Business Cycle
Growth and inflation data reported in February continues to accelerate and exceed expectations. U.S. real GDP forecasts have increased from 4% to 5%, with top economists projecting 7-8% real GDP growth in 2021. 53% of our growth indicators and 50% of inflation indicators are accelerating. Key indicators of cyclical activity (stock/bond ratio, copper/gold ratio, credit/Treasury ratio, banks/gold ratio) show clear signs of accelerating global growth and confirm our view of the global economy has entered the early recovery phase. The Macro Risk Indicators (MRI) is at -0.31 standard deviations.
We are closely watching the swaps market, where inflation expectations are starting to rollover. The market consensus is fully positioned for reflation. In our view, any surprise shift in the reflation narrative would not be well received by the capital markets.
Market Cycle
As we discussed in our 2021 Investment Outlook, interest rate volatility is spiking higher in response to market indigestion of the supply of new debt and growing deficits. The ICE BofA MOVE Index closed February at 76, its highest level since the start of the pandemic and well above its 5-year average of 60. Meanwhile, its equity equivalent closed the month elevated at 27.
The 10yr-2yr yield curve (swaps) steepened to 160 basis points from 74 basis points last summer.
Since the start of the pandemic, 10yr breakeven rates have moved from 0.55% to 2.17%. Notably, 10yr Treasury risk premium jumped from -0.95% to +0.26%. We can infer a fair value for the 10yr Treasury note yield of around 2.50%, or another 110-basis points from current levels.
Investment Grade corporate bond spreads are rich (100th percentile) relative to high yield spreads (90th percentile) and emerging market debt (45th percentile). All credit sectors' spreads are trading well below their 200-day moving average.
Year-to-date, investment-grade credit returned -4.1% and high yield -0.6%. RiskBridge looks to the credit markets for clues about the stock market and what we see is somewhat concerning.
Our implied equity risk premium model suggests U.S. stocks are overvalued by 5%. We believe valuations are most compelling in Latin America, China, emerging markets, U.S. value, and EAFE. Our analysis suggests growth stocks and small-cap equity valuations are at extreme levels. Consensus S&P 500 EPS are $174/share (24% y/y), which infers a forward P.E. ratio of 22x. If the U.S. real GDP growth is 8%, corporate earnings could achieve $200/share (19.4x P.E. ratio). Our analysis suggests stock market valuations begin to derate to their long-term median (17x) when the U.S. 10-year yield is closer to 2.25%.
In a recent interview with Business Insider, Jeremy Grantham of Boston-based asset manager GMO said, "This bubble is more impressive even than 2000, which was the champion. About 80% of the value measures have this one higher. We'll be rather lucky to have this bubble last until May."
We don't know if Mr. Grantham will be right about his narrative. Rather than guess, we continue to follow our analysis of the liquidity, business, and market cycles and focus on what we can control: the amount of risk and types of risk that go into a client's portfolio.
MVP Update and Rebalance – March 2021
RiskBridge's Managed Volatility Portfolio (MVP) model returned 2.25% MTD versus its benchmark[1] return of 1.09%, outperforming by 116 basis points. The MVP returned 1.71% YTD versus the benchmark's return of 0.22%, outperforming by 149 basis points. Past performance does not guarantee future results.
Year-to-date contributors are tactical equity allocations, overweight international equities, and exposure to core U.S. stocks. Detractors are cash, core-fixed income, and credit.
Portfolio Positioning
Historically, the market rewards different asset classes, sectors, and factors depending on the prevailing economic regime. Tactical portfolio tilts to reflationary regions (U.S., U.K., and Australia) may differ from tactical allocations for areas in the "restart" or "stagflation" regimes.
For March 2021, MVP portfolios are allocated as follows:
Modeled volatility is 10%, in line with its strategic volatility target.
The portfolio is underweight equities (-5%) and fixed income (-1%) with corresponding overweight positions in cash (+3%) and commodities (+3%).
Equity allocations are underweight U.S. core and small-cap stocks and overweight large-cap value and international developed markets. We are neutral emerging market equities. We have tactical tilts to energy, financials, and U.S. minimum-volatility stocks. We closed our communication position.
MVP fixed-income allocations overweight cash and short-term notes, underweight government bonds, and neutral credit. MVP duration is 5.4 years versus 6.0 years for the benchmark.
[1] 60% S&P 500 Index/40% Bloomberg Barclays U.S. Aggregate Bond Index
Bill Kennedy, CFA
DISCLOSURE: Past performance is no guarantee of future results. Investment involves risk.
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Benchmarks and indices are presented herein for illustrative and comparative purposes only. Such benchmarks and indices may not be available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, management or performance fees, and have limitations when used for comparison or other purposes because they, among other things, may have different strategies, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments) than RiskBridge account. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark or index. We make no representations that any benchmark or index is an appropriate measure for comparison. Please see below for brief descriptions of some of the major indices mentioned in this material:
The S&P 500® Index is a market capitalization-weighted index of 500 of the largest U.S. companies, designed to measure broad U.S. equity performance.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based market capitalization-weighted bond market index representing intermediate-term investment-grade bonds traded in the United States.
The Core Personal Consumption Expenditure Price Index provides a measure of people's prices for domestic purchases of goods and services, excluding food and energy prices. The core PCE is the Fed's preferred inflation measure.
The Cboe Volatility Index (VIX) is a real-time market index representing the market's expectation of 30-day forward-looking volatility. Also known as the "Fear Index, it is used as a way to measure market risk.
The ICE BoA MOVE Index is a well-recognized indicator of U.S. interest rate volatility and bond market sentiment that measures the implied yield volatility of a basket of one-month over-the-counter options on 2-year, 5-year, 10-year, and 30-year Treasuries.
The Merrill Lynch 10-year U.S. Treasury Futures Total Return Index measures the performance of a fully collateralized rolling 10-year U.S. Treasury futures position.