Joe Zidle: You Say Tomato, We Say …
It may have become assumed under former Fed Chairs Greenspan, Bernanke and Yellen that the Fed would “say something” to protect investors. But the Fed doesn’t exist to underwrite equity prices. The market’s current correction seems like it can be traced to what market experts interpreted as hawkish comments from Fed Chair Powell, and their conclusion that: 1) the “Fed Put” was over and 2) higher real yields (10-year Treasury yield less CPI excluding food and energy) would finally deal a blow to equity valuations. However, volatility’s return does not necessarily herald the end of this cycle. In our view, fundamentals remain strong and indicate this bull market is unlikely to end soon.
Real Rates Are Not a Meaningful Concern February of this year marked the first time real rates had increased by 2% since 2013.(1) After a brief decline, real yields began creeping upward again and broke 1% in October.(2) Rising real yields combined with additional Fed tightening wouldn’t seem to be the best mix for this economic cycle. But here’s the thing: real yields are not a harbinger of equity underperformance. In fact, since 1970, small caps and large caps return an average of 23% and 19%, respectively, when real yields rise by more than 2%, while bonds underperform.(3) The same analysis shows that even when real yields start negative and then rise to positive territory, equities still outperform by a wide margin.
Total Returns during Periods of Rising Real Yields (1970–2018)(3)
Source: Blackstone Investment Strategy and Morningstar Direct, as of 9/30/2018.
Volatility Is Not Always Scary The Cboe Volatility Index© (VIX Index©), commonly known as Wall Street’s “Fear Gauge,” spiked above 25 on October 24. Before February, the VIX had not been at that level since mid-2016; for context, its trailing five-year average is below 15. However, volatility doesn’t always portend trouble. After all, as of last week, a mid-2016 investment in the S&P would have yielded a 37% cumulative total return.(4)
Look for Confirmation in Treasury and Credit Markets History shows that credit and fixed income investors are better at identifying economic risk than equity investors. The Merrill Lynch MOVE Index, an indicator of bond market volatility, and corporate credit spreads have not broken out to the same extent as the VIX. The MOVE Index has bounced off its historic low and credit spreads are widening, but both remain below their trailing five-year averages.(5) This suggests that credit markets do not detect significantly elevated risk or deteriorating fundamentals. Excessive spread widening would be cause for concern, but current levels are basically normal.
Portfolio Positioning Volatility is always a test of investors’ mettle. Turning to fundamentals can help calm nerves when conditions appear troubling, and at this point, fundamentals do not suggest the bull run will end any time soon. Investors should position to benefit from possible equity outperformance with conditions favorable for small caps to beat large caps and bonds to be pressured by rising rates and real yields.
1. Source: Blackstone calculations of Bloomberg and Federal Reserve data. Real yields represent the 10 Year Treasury yield less core inflation (CPI less food and energy.) Represents period from 7/8/16 to 3/20/18.
2. Real yields hit 1.03% on 10/5/18.
3. Represents the following periods since 1970 (earliest available data for all indices) for which real yields rose by greater than 2%: 1/22/71-8/7/73, 2/21/75-5/21/76, 12/31/79-2/26/80, 6/16/80-8/8/83, 1/16/84-5/30/84, 8/29/86-10/15/87, 9/8/93-1/3/95, 10/5/98-1/20/00, 12/30/08-4/5/10, 6/1/12-1/1/14, 7/8/16-3/20/18. Returns for periods greater than one year are annualized. Fama-French indices utilized for value and growth indices. Ibbotson Associates indices utilized for small cap, large cap, cash and bond indices.
4. Source: Bloomberg, represents the cumulative total return of the S&P 500 with dividends reinvested in the index, from the period 6/24/2016 (the most recent date prior to 2018 that the VIX hit 25) through 10/24/2018 (when the VIX hit 25.23).
5. Source: Bloomberg, as of 10/24/18. Represents the Merrill Lynch Option Volatility Estimate (MOVE) Index, and the US Corporate BBB/Baa — 10 Year Spread Index.
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