History is the version of past events that people have decided to agree upon.
Dec 9, 2014 – Russ Koesterich, CFA Chief Investment Strategist and Head of the Model Portfolio & Solutions
Business Investment Directions 2015 MARKET OUTLOOK
Weekly Commentary Overview
- Many commentators blamed last week’s market turbulence on the plunging oil price. But to our minds, the selloff was more about lingering geopolitical issues and a pending Federal Reserve (Fed) rate hike.
- Given that, look for more volatility in 2015 as the Fed begins to normalize rates. This has several ramifications for investors.
- First, expect volatility to be elevated compared to the levels witnessed from 2012 to 2014.
- Second, be more tactical within fixed income. Two- to five-year bonds are likely to prove the most vulnerable to higher rates.
- Consider a “barbell strategy,” emphasizing longer-maturity bonds balanced against those with very short maturities.
A Stormy Start
Financial markets got off to a rough start in the year’s first full week of trading, experiencing severe bouts of volatility and ending with losses. The Dow Jones Industrial Average gave up 0.53% last week to close at 17,737, the S&P 500 Index declined 0.68% to 2,044, and the Nasdaq Composite Index slipped 0.46% to 4,704. Meanwhile, the yield on the 10-year Treasury fell from 2.11% to 1.97%, as its price correspondingly rose.
Many commentators blamed last week’s market turbulence on the plunging oil price. But to our minds, the selloff was more about lingering geopolitical issues and a pending Federal Reserve (Fed) rate hike. Given that, look for more volatility in 2015 as the Fed begins to normalize rates. This has several ramifications for investors.
Safe Havens Prevail Again
Volatility––as measured by the VIX Index––hit a one-month high of nearly 23 last week, and the losses that ensued were not limited to equities. High yield and emerging market bonds also fell, with the spread––the difference between their yields and that of U.S. Treasuries––widening 25 basis points (bps) and 30 bps, respectively.
Not surprisingly, the so-called “safe haven” bonds fared better as the combination of risk aversion and lethargic global growth pushed up prices and drove yields lower. The yield on the 10-year U.S. Treasury closed below 2% in the second half of the week. Aside from October’s “Treasury flash crash” (when yields suddenly fell below 2%), this was the first sustained move below 2% since the spring of 2013. Yields moved even lower in Europe, with 10-year German Bund yields falling to a record low of 0.44% and five-year yields turning negative for the first time ever.
Investor anxiety was driven by geopolitical concerns, namely politics in Greece, where yields on 10-year bonds traded above 10% for the first time in over 15 months. Anxiety there was accompanied by the same in Russia. The cost of insuring Russian bonds against default rose to the highest level in almost six years.
What is changing the investment landscape is the growing likelihood that the Fed will hike interest rates this year for the first time since 2006.
Conditions Right for Rate Hike
Neither the issues in Greece or Russia are particularly new. What is changing the investment landscape is the growing likelihood that the Fed will hike interest rates this year for the first time since 2006.
More evidence to support that view came from the December employment report released on Friday. Job growth continues to accelerate, as evidenced by the 252,000 in net new jobs last month. The previous two months’ totals were also revised higher by 50,000. True, wage growth unexpectedly fell and the labor participation rate is still stuck at a 37-year low. But these issues are structural, not cyclical, and, therefore, do not lend themselves to continued monetary accommodation.
Bottom line: With the economy on solid footing, the Fed should start to move sooner rather than later, probably by June.
Two Tips for Investors
This brings with it several implications for investors. First, expect volatility to be elevated compared to the levels witnessed from 2012 to 2014. This suggests strategies that thrive in “low vol” environments—notably momentum—may struggle this year. Instead, we suggest investors consider more value-oriented and high-quality names in a portfolio.
Second, be more tactical within fixed income. Bonds with maturities in the two- to five-year range are likely to prove the most vulnerable to higher interest rates. It is worth highlighting that while 10-year Treasury yields are down over 1% from a year ago, two-year yields, which are more sensitive to the Fed, have actually risen since the start of 2014. Our best advice is to consider a “barbell strategy,” emphasizing longer-maturity bonds balanced against those with very short maturities. This is particularly true for tax-exempt bonds, which we believe still offer good value for long maturities.
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