Broadly, equities and bonds are starting to show their wear following a decade of low interest rates and positive economic growth. Economic fundamentals suggest a growing economy at risk of overheating, signs of inflation, and uncertainty over the Federal Reserve’s preferred pace of interest rate hikes.
After much discussion of uncommonly calm equities this late in a bull market, volatility finally resurfaced in early February due in part to nascent signs of inflation and the resulting threat of more aggressive interest rate hikes.
The S&P 500 and Dow entered correction territory, both dropping more than 10 percent from late January highs. The Dow experienced two 1,000-point plunges in February before recovering roughly three-quarters of those losses. It was one of the most volatile months for equities since 2008.
The plummet sent a not-so-subtle reminder of why fixed income is a key component in managing portfolio risk. It may serve as a ballast against market volatility many investors have not experienced in years.
Looking inside the Fed’s interest rate policy
In this climate, the focus remains on how quickly the Fed will normalize interest rates. What is driving its decision-making process?
First, the Fed has a strong desire to slow asset price increases to ward off the risk of a bubble. Equities continue to trade at or near historical highs, and rising interest rates is one tool at the Fed’s disposal to limit asset bubble risk.
Another factor in the Fed’s stance is its need to “re-load the gun” of normalized rates before the next downturn. If rates remain historically low, the Fed will not have monetary policy at its disposal to re-ignite the economy, much like it did after the 2007 market crash.
Because of these dynamics, we believe the burden of proof may have shifted toward hiking interest rates. New Fed chairman Jerome Powell indicated as much before the House Financial Services Committee in late February.
Powell offered an economic outlook of robust growth and strong tailwinds that brings about a new set of challenges, namely concern of an economy growing too quickly. If positive economic data continues, he hinted at becoming more aggressive with future rate hikes despite the volatility that greeted the beginning of his tenure. The Fed may have started down that path by lifting the federal funds rate by 0.25 percent in late March.
It appears that Powell is ushering in a new era of monetary policy, with signs indicating a baseline of three rate hikes in 2018 with the increasing potential of a fourth.
[Related:Hear portfolio manager Michael Terwilliger’s audio summary of this Commentary]
Inflation is the main driver as the Fed charts its next move. The Consumer Price Index jumped 0.5 percent month-to-month in January, beating its 0.3 percent estimate, before modestly rising 0.2 percent in February.
Rising wages and lower unemployment are also putting pressure on inflation. February’s jobs report included a 2.6 percent annualized average earnings increase. Meanwhile, the labor market continues to show signs of tightening, with the number of new unemployment applications recently dropping to its lowest level since December 1969.
With wages on the rise and tax cuts about to kick in, robust consumer spending should continue. Savings recently reached their lowest point since the peak of the early 2000 housing boom, and consumers continue to borrow. Increased consumer debt is a sign of expanding economic confidence, and this quickening pace of consumer sentiment will unquestionably contribute to broad-based inflationary pressure.
Seeing these price and wage pressures, chairman Powell announced on Capitol Hill in February that the Fed anticipates inflation to stabilize around the Federal Open Market Committee’s two-percent benchmark. If this belief holds true, it will certainly put further pressure on interest rates.
Unfavorable dynamics for traditional fixed income
This backdrop only heightens the headwinds facing traditional fixed income. Recent Treasury spikes underscore the real risk of principal erosion for fixed-coupon fixed income.
Buying bonds as interest rates rise comes with an opportunity cost of capital. If rates continue to go up, the bonds bought today must come down. That is the exact opposite of what investors want from their fixed-income portfolio.
Floating-rate assets, on the other hand, pay higher interest as rates rise and are better positioned to avoid a loss of principal in today’s environment. Additionally, senior secured loans are secured, typically by a first lien on the issuing company’s assets like property and equipment. Conversely, unsecured bonds, for example, may be subordinated to other senior debt and fall even further down the capital structure. This puts senior secured loans in an even more favorable position to potentially preserve principal as rates rise.