Commentaries

The Envestnet Edge, November 2016

Rotations, Reversals, Rising Rates: A Time to Reposition

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The Federal Reserve’s intent to raise rates, coupled with the election of Donald Trump, may have ignited a Great Rotation from bonds to equities, calling into question the relative safety of bonds that investors have experienced over the past three decades. This month, we examine the selloff in bonds and the stock market’s surge, and discuss the need to reposition portfolios to benefit from the Great Reversal.

For several years, investors have anticipated a “great rotation” from bonds into equities, and for several years, they were dead wrong. In fact, even as equities were quietly rising for the past years, both domestic and international money has continued to surge into bonds. At long last, that is beginning to reverse, which demands a reconsideration of strategies that seemingly have worked so well and so easily for so long. As long as bond prices were rising, pouring money into assets that had a certain return looked like a slam dunk. No longer.

The reversal

The primary reason for the decades-long bond bull market is simple: Since 1982, bond prices have risen as interest rates have fallen. There have been several periods of bond volatility, most recently with the “taper tantrum”, as markets adjusted to the end of the Federal Reserve’s (Fed) policy of quantitative easing. But for the most part, bonds have been on a three-decade-plus bull run. Meanwhile, more volatile and unpredictable equities have gone through intense periods of double-digit gains and losses. Add to that a general climate of skittishness that has bested financial markets and financial players since the 2008-2009 crisis. When traders and markets panic, their panic is usually first manifested in equities, given their liquidity. Although arcane corners of the credit markets are also susceptible to panic and sharp flux, they usually are less evident, and ebb and flow without triggering reactions elsewhere in the financial ecosystem.

Two things, however, changed sharply in the past months: the evidence that the Fed is ready to bring short-term interest rates back up (modestly) and the election of Donald Trump.

The Fed now has the evidence to support what it has wanted to do for some time. Headline unemployment is below 5%; there is modest (though uneven) wage growth; and inflation is pushing 2%. It hardly represents an overheated economy, but it is sufficient to bring the most extreme easing to an end.

Make no mistake: This is not your grandfather’s tightening. Increasing short-term rates from 25 basis points to 1% would still leave those rates far lower than at most points in the 20th century, and an expectation that normalization is ahead that will bring rates back to that point is almost certain to be wrong. But in relative terms, this is still a degree of tightening, and global bond markets have begun to take notice.

But it took the election of Trump on November 8th to push those trends into higher gear. Within days, bond prices began to fall and yields surged rapidly, to over 2.25% on the US 10-year Treasury note, and even more on longer-dated bonds. One bellwether of longer-dated bonds, the Vanguard Long-term Bond Index (BLV), lost nearly 8% in a matter of days. Equities also surged, surprising many who had predicted that a Trump victory would lead to a 5-10% pullback in stocks. Instead, the S&P 500 rallied nearly 4% in the days after.

Even more intriguing was where the money started to flow: out of bonds, out of U.S. bonds, and into sectors of the market that had been lagging, such as financials and industrials. The reasons were straightforward: Trump, it is believed, will unleash deregulation, along with massive infrastructure and tax-cut plans that will spur inflation and boost domestic industry. Hence why construction-related sectors and companies surged (look at how Caterpillar and John Deere performed in the days after the election), why banks surged (look at the exchange trade XLF as a proxy for financial stocks), and why utilities and other sectors where investors had sought safe yields sold off.

The sharp and sudden reversal in bond prices and surge in yields also should be a wake-up call for investors who have grown used to bond market placidity. Especially for longer-dated bonds, the moves were not only sudden, but potentially jarring. To lose 8% on a supposedly stable investment will come as a shock to some who had thought of these investments as safe and steady. Nothing in financial markets should be considered truly steady, and the perception that bonds are immune to volatility is surely one of the great distortions of our time.

What now

The implications of the possible Great Rotation are profound. First, portfolios with excessive allocations to bonds as safe harbors will underperform. Some of the reaction to Trump’s election is likely short-term, as foreign investors may have pulled out of US issues in reaction to the sheer uncertainty of a Trump presidency. Those who expect strong  inflation are also likely to be disappointed, as the ingredients for sustained global price rises do not appear to be in place (which the weakness in gold also seems to signal). But the suddenness of the moves, and the way investing positioning and sentiment can reverse more quickly than you can adjust, ought to remind us emphatically that waiting until a rotation happens to reposition properly is waiting until it is too late.

Excessive allocations to stocks that look like bonds because they appear to offer steady prices and consistent yields is also a mistake, as the sagging utilities and staples equity sectors showed during the reversal. Whereas stocks can be attractive in part because of what they yield, pouring money into stocks that look like bond proxies is a mistake, because when bonds reverse, those stocks will, too. In short, stocks that look like bonds will behave like bonds, which kind of defeats the purpose of diversification.

Following the momentum names in equities is also likely a mistake, as the construction and commodity-related names that surged in expectation of a Trump infrastructure plan may not see any tangible benefits for quite some time, if at all.

But positioning for a modest end to the thirty four-year bond bull market by bringing one’s equity allocation back in line would be wise, at the very least. Considering a more substantial equity allocation should this Great Rotation pick up additional steam would also make sense. And on a somewhat counterintuitive note, taking advantage of the sharp pullback in longer-dated bonds, emerging markets bonds, and even high yield could also be fruitful if (as is likely) the post-election reaction proves to be either an overshoot or a reset. Long-dated bonds may not rally at all, but is another 10% decline in price likely in the near term?

The basic lesson of the Great Rotation is the need to think about where the next shift will be, rather than relying on the status quo as a safe guide. It has been easy to dismiss expectations of prices resetting and assets shifting from bonds to equities as long as that wasn’t happening. There are now signs that is, and it’s best to be positioned
accordingly.

November Takeaway:

Bonds were the safety trade—dependable returns, with little volatility. The Fed’s almost-certain decision to hike rates in December, coinciding with the election of Donald Trump, may have spurred the Great Rotation: a stock market surge that few predicted. Rising rates, untangling regulation, cutting taxes, and building infrastructure all signal a shift from the relative safety of bonds to a more equity-weighted portfolio. Investors should think about where the next shift will be—waiting too long before repositioning portfolios may be a mistake.

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this commentary is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results. Indices are unmanaged and their returns assume reinvestment of dividends and do not reflect any fees or expenses. It is not possible to invest directly in an index.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet | PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Neither Envestnet, Envestnet | PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.

© 2016 Envestnet, Inc. All rights reserved.

Featuring

Zachary Karabell
Head of Global Strategies, Envestnet, Inc., Consultant to Investment Committee*

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