The Recent Market Volatility – Your Questions Answered

We all know markets go up and markets go down, but the recent decline in both equity and fixed income markets can be unsettling. During times like these, it is helpful to review the underlying aspects and new developments within each of these asset classes, and to reflect on any allocation changes that may be appropriate. Below is an interview with Round Table’s Chief Investment Officer, Bob Davis, to put this week’s market volatility in perspective.

Q: Fixed Income – what’s going on in the market right now, and what’s changed?

A: For many years now, fixed income markets have been characterized by low interest rates. The Federal Reserve has been sufficiently transparent in their path to increase rates at a “measured pace” as the economy recovers, and fixed income markets have not experienced unusual volatility.

However, last Friday the average wage paid to employees across the U.S. was reported to have increased more than expected. Combined with unemployment at 4.1% (near levels consistent with “full employment”), the market’s conclusion was that rising wages would create higher inflation, which would then cause the Federal Reserve to increase interest rates faster than previously communicated. As a result, interest rates in the market have moved up quickly—the 10-year Treasury has increased 18.3%, most recently to 2.84%[1] up from 2.40% at the beginning of the year. Our expectation is that rates will continue to rise

Q: What changes are you making to your fixed income portfolios in light of this?

A: We maintain our standing neutral recommendation to fixed income. In this context, our Investment Committee recommends adjustments, where appropriate, to reduce average duration across client portfolios to approximately 4 years. The net effect of this move will be to lessen the impact of higher interest rates, while not excessively reducing fixed income yield.

In addition, we will maintain our existing floating rate loan exposure. Floating rate loans, which we have advocated for some time now, have held up well, providing a year-to-date return of about a positive 0.90%. Fixed income markets, as measured by the Barclays Bond Aggregate Index, are down about 2% for the year-to-date, with longer duration indices down more.

Q: What about the equity markets – what’s happening there? Why are the news headlines in crisis mode?

A: We believe equity markets have reacted to changes in the fixed income markets in relation to the higher discount rates and return premiums that are required in a higher volatility environment. As you may know, corporate equities are valued based on the projected future cash flows generated by a business. Those cash flows are discounted at a given interest rate, the sum of which determines a company’s equity value. As the interest rate used for discounting purposes increases, the sum of future cash flows, or the equity value, decreases, and this is reflected in lower share prices.

Volatility is also reflected in share prices. Equity market volatility over the last several years has been historically low. The combination of low interest rates and low volatility provided a backdrop for equity share prices to increase, as the “risk” of owning them was low. As we move into what appears to be a higher volatility environment, the required return on equity increases, such that investors can be adequately compensated for the risk of owning equity shares. The recent sharp decline in equity indices may be a reflection of this higher risk premium.

We further believe that this recent spike in volatility has been exacerbated by the financial products that make leveraged bets on volatility—especially those that bet inversely to volatility—which have proliferated the retail investing environment.

Q: We keep hearing that the market’s dropping like it’s 2008. Should investors be worried?

A: Putting the technical aspects of the market aside for the moment, we need to focus on the fact that corporations in the U.S. and abroad are doing quite well. U.S. corporate earnings are strong and improving. S&P earnings are projected to grow 12% in 2018 and many companies are raising earnings guidance. Similar dynamics are at work in non-U.S. developed and emerging markets. (As an aside, those markets have held up better YTD than U.S. markets, and underscores our overweight to those regions.) In the long run, equity returns are generated by earnings growth. Given the strong underlying corporate fundamentals, we believe the market correction taking place will be short-lived and the re-valuation (think lower market multiples) will create a new level at which to own equities. Returns in equities, we believe, will continue to be generated, provided corporations are able to deliver on earnings.

Q: Are you making changes to your equity portfolios?

A: Following the consensus of our Investment Committee, we are not recommending any changes to equity allocations at this time, unless those changes are to rebalance back to a given client’s long-term allocation. Remember: selling a security requires two decisions, not one. The first is to sell, the second is when to repurchase. As we believe the equity markets continue to have return potential greater than cash and bonds, selling shares creates both a tax consequence and an inefficient use of capital. We maintain our standing recommendation to have a neutral/underweight allocation to U.S. large and SMID cap equities, and an overweight to both non-U.S. and emerging market equities.

 

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By |2018-12-07T20:55:38+00:00February 9th, 2018|Blog|Comments Off on The Recent Market Volatility – Your Questions Answered

About the Author:

Robert Davis is a Partner and the Chief Investment Officer of Round Table Wealth Management.