Why I am not changing my portfolio even though the yield curve has inverted

On Friday it was reported that the yield curve in the US inverted for the first time since the last (great) recession. This is supposed to be a reliable harbinger for a future recession in 12-18 months.

What does it mean when the yield curve inverts?

It means the US short-term interest rate (as measured by the 3 month Treasury Bill rate) is now higher than the long-term interest rate (as measured by the 10 year Treasury Bill rate). An inversion like this is generally regard as a negative market/economic sentiment that can affect economic and market behaviour.

The yield curve inversion has sent some scurrying to make changes to their portfolios by raising cash, selling riskier stocks and becoming more defensive (buying utilities, telcos, REITS and consumer staples equities).

Why I am not scurrying to do anything on the news:

  1. I already have some cash (about 10% of my portfolio, including high-interest savings and short-duration bonds maturing later this year)
  2. I already have good exposure to defensive equities: ~18% utilities + ~11% consumer defensive + ~6.5% communications services + ~3.5% real estate = ~39.0% defensive
  3. I have less than 50% of our total portfolio in equities so a market downturn should be offset somewhat by non-correlated holdings in fixed income, cash and bullion (this was true in 2018, when my portfolio returned ~+1% in spite of equity drawdowns in Canada and the US)
  4. If I sell something to raise cash there could be tax consequences in our non-registered accounts, due to potential capital gains being taxed
  5. I don’t know which non-defensive equities to sell to raise cash – I like all my holdings for the long haul or I wouldn’t own them
  6. Recessions tend to be short and I believe my long-term portfolio is structured well for riding out short-term events
  7. An inverted yield curve has reportedly accurately predicted upcoming recessions eight times (by some sources) since 1968 but, if on January 1, 1968, I bought and held the S&P 500 (^SPX) I would have made a return of 2.81K% in spite of the eight recessions (including the Great Recession of 2008-09)
  8. According to Forbes, the chance of a recession in the next year is always about 27% (based on their data pointing to 16 recessions since 1960) and today the chance is 30%, hardly more than average
  9. If the chance of recession is 30% next year there is also a 70% chance there won’t be a recession next year which means, based on probabilities alone, I should be buying risk-on stocks
  10. If the US Fed surprises by lowering interest rates, that could change the situation immediately
  11. I don’t know how to time when to start re-buying the risk-on equities I am supposed to sell now – presumably when the yield curve corrects to non-inversion

I am not saying a recession won’t happen in 2019-20. It may well.

What I am saying, as a long-term investor who buys, holds and monitors a portfolio of retirement assets designed for all markets, who relies primarily on asset allocation rules when making security weighting decisions, and who makes limited and selective trades intended to improve overall portfolio quality, I don’t react to news like this.

Do you?

 

 

 

More on sequence of returns risk

Sequence (of returns) risk is something I mentioned in my recent piece about my upcoming third quarter portfolio review. Sequence risk is a major factor in my planning as our household heads into retirement in the near future.

Looking at the current valuation of the S&P 500 vs. underlying gross national product is a bit sobering.

More on this here.

Previewing my next quarterly household portfolio review

September brings my next quarterly portfolio review and my next, self-imposed, securities trading window (I only trade four times a year). I have been giving a fair bit of thought this summer to what’s next for our portfolio.

Here’s a preview of my thinking….

 

 

 

 

 

What US macro risks are investors facing these days?

It’s been over a year since I last wrote about macro risks emanating from the US and how they might affect Canadian investors.

Given how many changes are taking place in the macro environment recently, and how influential the US macro situation is for Canadians, I thought it would be interesting to do an update. The idea is to try to identify major driving factors that might affect US, Canadian and global equity markets in an effort to reduce the “surprise factor,” which may in turn lead to bad investment decisions (out of fear or panic).

So what does the macro risk profile look like south of the border? No one really knows for sure of course, but it is interesting to contemplate, especially if you have any US holdings in your portfolio.

Let’s take a look at some of the frequently-cited risks that may affect investors and try to determine if relative risk levels have increased or decreased since my last effort at this in January 2017.

I have listed them from what I propose are the highest to the lowest risks.

Notation used:

⇑ = risk is increasing

⇔ = risk is not changing

⇓ = risk is decreasing


Tax Risk = ⇑ (increased risk rating since Jan/17)

Definition: the risk that an investment will lose its value or return on capital because of taxation (most investments are subject to this risk)
My take: Recently, Trump decided to impose new taxes, in the form of tariffs, on steel and aluminum, and on various goods manufactured in China. China is already beginning to retaliate, raising the prospect of a trade war. It is unclear if Trump will lay on even more tariffs. It remains to be seen what the economic impact of new tariffs will be but the general consensus appears to be net negative due to rising costs of goods for consumers. Corporate and limited personal income tax cuts were delivered in December 2017 so that matter is settled for now.


Political Risk = ⇑ (same risk rating as Jan/17, but the overall risk is likely higher)

Definition: the risk that an investment will lose value because of political action in a country where one has investments, including one’s own country
My take: While his core support seems to be holding, the US president remains erratic and sensational in policy pronouncements, his cabinet turnover is record-setting, new cabinet and legal advisory appointments are arguably increasingly controversial and recently look like they are veering hard to the right of political spectrum and more confrontational in tone. Relations with Iran may become increasingly strained while relations with North Korea could possibly (but not likely) improve (the new national security advisor, John Bolton, advocates war with both countries). The president continues to accommodate, even congratulate Russia while many observers suggest this is inappropriate given demonstrable evidence of Russian interference in the last US election among several other concerns. The Mueller investigation continues to slowly gain momentum on three fronts: Trump’s possible (likely?) obstruction of justice; Trump/team conspiracy with Russia to tip the last election; and Trump/family financial dealings, including potential money laundering. New revelations about Cambridge Analytica’s role in the 2016 election and potential connections to Russian interference are gaining a bit more traction. The trial for Paul Manafort, Trump’s former campaign chairman, begins in July and further indictments by Mueller in other cases remain likely. The ongoing investigation means a constitutional crisis could easily be triggered if Trump does indeed fire the Special Council as he reportedly intended to do last summer, and may be more inclined than ever to do given his recent appointment of Joseph diGenova, who claims the domestic security establishment (a.k.a. “deep state”) in the US is trying to frame Trump. The possibility of impeachment is likely remote still, but increasing. There are mid-term elections in November which could lead to one or both Houses of Congress flipping to the Democrats, thus hobbling Trump’s agenda and making him accountable. Given all this uncertainty, I believe political risk is elevating in the US and by extension the world.


Market Risk = ⇑ (same risk rating as Jan/17, but the overall risk is likely higher)

Definition: the risk that an investment can lose its value in the market (applies to equities and fixed-income investments)
My take: Given the US market had been climbing steadily since November 8, 2016, the recent pullbacks have been long overdue. Most market gyrations tend to be short-term in nature and are of little consequence to long-term investors. Many commentators still claim the market is over-valued based on historical price/earnings ratios. Overall though the backdrop of corporate earnings, economic growth and planned orderly increases in interest rates contribute to medium term optimism in equity markets. There are no compelling hints of a recession yet on the horizon. Having said that, volatility has been increasing so far in 2018 (the ^VIX is up 125%), in large part due to increasing political, inflation and tax uncertainties. Market risk is being reflected CNN’s Fear and Greed Index (7% out of 100%) and in the recent drops in major indexes. Of the three major US indexes, only the NASDAQ is in the black so far this year. I would suggest market risk is rising due to heightened uncertainty in the political and tax environments discussed in this post and the recent increase in volatility.


Legislative Risk = ⇔ (reduced risk rating since Jan/17)

Definition: the risk that an investment will lose value or benefits because of new legislation (all investments are subject to this risk)
My take: This risk is related to political risk. The most recent spending law (as of writing today still unpassed before a midnight deadline) appears to be ignoring fiscal conservatism. Regulations related to offshore drilling, the environment and banking have been changed and, again, in the short to medium term are being well-received by investors. Longer term, these changes could be damaging to the US economy by contributing significantly to increased US fiscal indebtedness, reckless banking practices, over-stimulation of the economy, environmental degradations and potential knock-on inflationary impacts. NAFTA talks drag on, with some signs the US may be softening its position, especially in the auto sector. If a new deal is not struck soon, there will be little time for Congressional ratification, leaving the future uncertain. We don’t know what else could be forthcoming in the legislative and regulatory environment, but presumably not too much will change before at least the fall mid-term elections. If in fact a Democratic House of Representatives emerges, this would likely provide a damper on Trump’s legislative agenda.


Interest Rate Risk = ⇔ (reduced risk rating since Jan/17)

Definition: the risk that an investment will lose value due to a change in interest rates (applies to fixed-income investments and sometimes to equity investments depending on investor expectations for interest rate changes)
My take: Interest rates are still on track to rise three times this year (once already this week) even with the appointment of a new Fed Chairman. With two more rate increases promised in 2018, on top of this week’s rate increase, the market should be prepared. Wage inflation, in large part due to low unemployment coupled with economic growth, could also be a driver of higher than expected interest rates later this year, which could be bad for equity markets. We saw the market react to some of these expectations earlier in the year. Due to the combined effects of tax cuts and increased deficit spending expected this year, the US federal debt will climb, which is not positive for rates longer term. This is a tough one to forecast at the best of times but on balance it would seem interest rate risk in the short to medium term has decreased since January 2017.


Purchasing Power Risk = ⇔ (reduced risk rating since Jan/17)

Definition: the risk that an investment will lose its purchasing power due to inflation (applies particularly to cash and fixed-income investments)
My take: This risk is somewhat related to interest rate and tax risks in that the main concern would be higher-than-expected inflation, driven by wages, higher health care costs and possibly new tariffs, but counterbalanced to some degree by lower personal and corporate taxes. If Trump’s policies end up being inflationary then purchasing power may erode. This would likely take some time to happen. On balance the risk of higher inflation, from a very low level since the 2008/09 financial crisis, has probably increased, but for the short to medium term does not appear very likely to happen. The recent tax cuts, especially to individuals, will marginally add to purchasing power in the short to medium term and low unemployment could eventually cause wages to go up, improving purchasing strength of individuals.


Liquidity Risk = ⇔ (same risk rating as Jan/17)

Definition: the risk that an investment will not be easy to sell when needed (applies to some equities that don’t trade in large volume, fixed-income investments and real estate and other property that may be hard to sell quickly at an equitable price)
My take: I don’t see any reason to think liquidity risk has changed since January 2017– at least not in the short term. If some of the other risks in this post materialize, this could change, and possibly quickly. I leave this risk at the mercy of “black swans” without changing the risk rating from January 2017.


Reinvestment Risk = ⇓ (same risk rating as Jan/17)

Definition: the risk that an investment will be reinvested at a lower rate of interest when it matures (applies to fixed-income investments)
My take: If we expect interest rates to continue an orderly climb higher in 2018, new money that is being invested in fixed income should attract higher rates. If one deploys fixed income funds to rate reset preferred shares and/or bond funds or bond/GIC ladders of short to medium term duration (e.g. five years or less) then reinvestment risk should be falling.


Are there any actionable ideas here?

I believe that several risks I am tracking are falling, but the three risks that I believe are increasing (political, taxation and market) could have major impacts in the short to medium term. Longer term I remain somewhat optimistic.

But….

With rates rising south and north of the border, and related sector rotation, there has been pressure on utilities, telecoms, consumer staples, materials and energy this year. Bond prices are slightly weaker so far this year as rates rise. I recently added to both utilities and bonds.

If the technology sector continues to outpace this year, I will at some point likely need to re-balance to reduce the percentage this sector represents in our portfolio. It is roughly 20% now and rising.

As stated over a year ago when last reviewing macro risks, I continue to balance short-term risk with longer term secular trends. Since January 2017 I have bought an ETF for robotics. I continue to hold biotechnology and water-themed ETFs and I continue to hold Shopify in the e-Commerce space (although I trimmed it somewhat last year). I am researching both alternative energy and cybersecurity as other possible investment themes for new cash in the future (and likely will be writing articles on them for Canadian MoneySaver).

In conclusion, it remains pretty much stay the course for me. I have an expectation that things will be more volatile in equity markets in 2018 compared to 2017. So I remain prepared for that eventuality. Otherwise, who knows?

Be greedy when others are fearful?

Just a quick post to point out that for the third time so far this year, CNN’s fear and greed index is down below 10 (on a scale of 0 to 100). This suggests, by its seven measures, investors are “extremely fearful” of the US equity markets right now.

Hmmm. What’s on sale in the markets? (Hint: telecoms, consumer staples, energy, utilities and materials).

What just happened to markets?

Headline stories about the stock market pullback this week were largely focussed on the drop in the Dow Jones Industrial Average (less so on other indexes, but they were not immune). The year-to-date total return marked by the DJIA on January 26 was +7.77%. By the close on Friday, the DJIA had settled to +3.34% YTD, a drop of around 4%.

This is a relatively large drop given the low volatility and upward trending we’ve seen in markets in the last couple of years. By historical standards this is a mere blip, and 3.34% YTD total return still represents, annualized, over 35% growth!

I was in my car last night and caught a story on the news radio about the stock market pullback. The commentator didn’t really have a very clear rationale for drop – something about markets and the broad economy not being correlated….. The broad US economy is doing well, creating jobs and growing, but markets took a big pause.  Hmmm. I didn’t find that very satisfying.

A few minutes earlier I had read in WaPo the main reason that markets pulled back, and especially on Friday, was to do with the 10 year benchmark interest rate surpassing 2.8%, on its way perhaps to 3%. The case was made that a 3% benchmark rate will send a signal to some investors that bonds might be more attractive than stocks on a risk-adjusted basis.

I read another article this morning in the NY Times that makes a similar point and goes on to say there may actually be a connection between the pullback and the broad economy: expectations are that the broad US economy is going to grow at, say, 1.5% not the 3% promised by Donald Trump.

So maybe there is a decent connection between stock market indexes and the broader economy after all. Given how expectations affect spending and investment decisions so heavily – both in markets and in the economy at large – this really shouldn’t be a surprise. And the 10-year interest rate moves in large part due to expectations about inflation rates and the cost of money in the future. Inflation expectations may be climbing.

This tells me, perhaps, that expectations could well be shifting to lower future growth rates in the economy and to lower investment returns from markets. Nothing says these expectations will be proven correct, but it is worth noting.

It is also worth reminding that last year’s market performance is no guarantee of future performance. But even at a 3.34% total return YTD, the DOW isn’t exactly off to a bad start.

Three things to watch for markets in the near future

At the time of writing, pre-market stock trading in the US is showing minor declines on the three major stock exchanges.

The US government shutdown is but one factor, even if an extension is voted in for the next three weeks.

NAFTA negotiations are about to start their sixth round on January 29th in Montreal. Reports have it that US/Canada relations are acrimonious and may lead to the US serving notice of withdrawal.  In a recent move, Canada has filed a World Trade Organization (WTO) complaint against the US. Donald Trump is signalling his considerable displeasure with Wilbur Ross as Commerce Secretary.

A third factor coming back on the horizon is the US debt ceiling, which is expected to be reached in early March 2018. Some are expressing concerns that it is aligning closely with budget debates.

With an erratic White House at the “helm” and over-stretched stock market valuations in the US and Canada, what could go wrong?

Here comes the US debt ceiling again, and the possibility of a government shutdown

I have mentioned a white swan event here before. But it was avoided for the time being.

We may see one or more again.

December 2017 will be a busy month legislatively for the US federal government. Along with tax cut legislation, Congress and the president must deal with the debt ceiling and the possibility of a government shutdown due to lack of funds.

December 8 is an important date to resolve the funding issues. The end of the year is the president’s imposed deadline for tax cut legislation.

Failure on any of these major initiatives will be embarrassing at best and potentially be very damaging to the US economy and market confidence at worst.

US markets are near or at all time highs and volatility is very low.

One could argue market sentiment is a bit too complacent right now.

If stocks go down, what’s your plan?

My thoughts from early 2016, when markets were pretty soft are here. While early 2016’s pullback seems like a long time ago, my perspective hasn’t changed all that much since.

Has yours?

 

Dotard vs. Rocket Man: Do the markets even care?

There has been lots of media coverage about the war of words between Trump and Kim (of North Korea). If a war does break out, some speculate as many as 25 million people could be casualties.

Do the markets even care? It would appear not so much, as new highs are being reached in the US. Asian markets are a bit more restrained.

If you are curious about the impact of wars on financial markets, 5i Research published a link from the CFA Institute that helps explain the historical response here.

In short, sad to say, a war between the US and North Korea might present a buying opportunity for stocks if they pull back short term.