Interest Rates – they rise and fall…but not in a straight line
In our June commentary, we referenced the peak of the 10-year treasury yield of 15.84% on September 30, 1981 and the all-time low of 1.43% on July 25, 2012. Rising rates will be with us for the foreseeable future. Simply because the downward path of interest rates took three decades does not mean that we are stuck with rising rates for the same duration, or that rates have to rise to the previous highs. There are many different factors, events, technological advances and geopolitical issues that will impact the future course of interest rates.
How will interest rates change over the next thirty years?
We can’t be certain, but history should give us some perspective. Let’s examine a previous period of increasing rates (6/1/62 – 9/29/81). One measurement of the 10 year treasury yield is called constant maturity treasury yield which removes price fluctuations. The initial base yield stood at 3.89% on 6/1/62. The chart to the left illustrates the number of trading days it took for the yield to increase by 1%. The average elapsed time for each 1% increment was 719 days. Rates will rise, but rarely in a straight line.
We do have lower expectations for bond performance in future years because rates should continue to rise; however, we are not advising clients to abandon their current allocation to bonds. Bonds are the anchor thats help stabilize a portfolio, while stocks and other more volatile investments provide the long-term growth. By adjusting the bond portfolio duration we can decrease the sensitivity to rising interest rates.
We have chosen FPA Advisors, managers of the FPA New Income Fund, as an additional bond manager in our portfolios. They are absolute return investors and not interested in relative performance to a benchmark. Their philosophy is simple: We do not like to lose money! Their goal is to generate a positive return over twelve months. This is evidenced by the fact that present management has generated positive absolute returns every calendar year since 1984. Their primary focus is “Return OF Capital” with a secondary focus on “Return ON Capital.” Market conditions will determine which is prioritized. They are subject to the same market forces as other investors but buy based on the worst case scenario. Make no mistake; we are hiring them for their ability to protect on the downside in a rising interest rate environment. If this were a declining interest rate period like the last thirty years they wouldn’t be considered.
FPA has demonstrated the ability to add value in rising interest rate environments as shown in the graph below. For the period 12/18/08 – 6/8/09, interest rates rose from 2.06% to 3.88%, for an 88% increase. During that period, the FPA New Income Fund was up 1.0% compared to the Barclays U.S. Aggregate Bond Index up only 0.24%. Because of their strict investment criteria, they were able add an additional 0.76% of return to their clients’ accounts. In the other periods, their added value exceeded 3% as shown below. We believe FPA’s strategy capitalizes on the current low interest rate environment where the magnitude of increasing rates is intensified.
FPA’s allocation in our portfolios will come from a reduction in intermediate bonds to reduce overall duration. The resulting allocation will be 30% FPA, 30% Templeton Global Bond, 20% PIMCO Total Return and 20% Metropolitan West Total Return. Trust accounts will maintain an allocation to Tennessee Tax Free Bond Fund of 40%, with complementary allocation of 30% to FPA and 30% to Templeton Global Bond.
Whether you view performance from market peak (10/7/07) or the market bottom (3/9/09), foreign stocks, represented by MSCI EAFE (developed international) and MSCI EM (emerging markets), have lagged US stocks represented by Wilshire 5000 (US).
The MSCI EAFE index has heavy exposure to Europe which has taken longer than the US to work through their financial problems. Europe is just beginning to see the light of day with an outlook for very slow growth. From an investor perspective European stocks have become very attractive relative to the US market.
The emerging market countries, though not directly involved in the global financial crisis, were indirectly affected. Emerging markets are heavily export driven and when their two largest trading partners, Europe and the US, are struggling economically, it takes the wind out of their sails. Additionally, the US Dollar has been strengthening versus other currencies, which creates a headwind for US investors owning foreign assets. These events among others have driven emerging market stocks to the point they are trading at a 35-40% discount to the US market.
What sometimes is forgotten is that the emerging market countries are over 51% of global GDP, so any growth they generate will be felt globally. Economically, emerging markets have come a long way in the last 10 years, currently representing over 11% of the world’s stock market capitalization, with a lot of room to expand. Their debt management practices are the envy of the world, where debt-to-GDP stands below 50%, as compared to the US or Japan exceeding more than 100% and 200%, respectively. Financial stability, good governance, low inflation, increased demand to support stock and bond issuance, and a liquid market for their currency all point to positive long-term futures for emerging markets.
Buy Low, Sell High
Year-to-date, emerging market and international stocks have underperformed US stocks significantly and bonds have underperformed stocks. Because of our commitment to a disciplined investment philosophy, we will be rebalancing accounts by selling what has done best and reinvesting in what has underperformed. This can make investors nervous but history tells us it’s the right thing to do. In 2008, we experienced one of the worst bear markets in our time and we stuck to our discipline by rebalancing when stocks tumbled. This meant we were buying stocks and selling bonds at a time when everyone else was heading for the exits. Looking back, it was exactly the right thing to do despite the emotional temptations.
For the period ending September 30, 2013, quarter-to-date returns for the S&P 500 (US), Russell 2000 (Small Cap US), MCSI EAFE (Developed International), MSCI ACWI (World Index), and Barclays U.S. Aggregate Bond indexes were 5.24%, 10.21%, 11.56%, 7.90% and 0.57%, respectively.