State of the Markets
As we head into the final months of 2019, markets have been impacted by concerns about the state of the global economy. Despite the potential impact of inverted yield curves, Brexit, slowing global growth, a decline in corporate earnings, and continued trade issues, markets overall have been having a good year. However, most of the gains occurred early in the year, as stocks rebounded from a sharp drop in late 2018.
As of the end of September, the U.S. stock market (Russell 3000) was up 1.2% for the quarter and 20% for the year. International developed markets (MSCI World ex USA IMI) had a slight loss of 0.8% for the quarter which brings the year-to-date performance to 13.4%. Emerging markets (MSCI Emerging Markets IMI) had a pullback of 4.3% for the quarter, but still had positive performance of 5.4% year-to-date. Publicly traded real estate (S&P Global REIT) had significant positive performance of 5.7% for the quarter which brings year-to-date gains to 22.2%.
The Federal Reserve enacted two rate cuts lowering their target rate from 2.5% to 2%. This resulted in positive performance for the U.S. bond market (Bloomberg Barclays U.S. Aggregate Bond Index) with 2.3% return for the quarter and 8.5% year-to-date.
The total returns for major asset classes are below.
Is the Next Recession Around the Corner?
We are currently in the longest economic expansion in U.S. history. It has been over 10 years since the Great Recession and the U.S. economy now has been in expansion mode for 123 quarters. Despite this being the longest expansion, it has also been the lowest aggregate GDP growth in post WWII history (as depicted in the chart below).
Given the maturity of the current expansion, there are concerns that the next recession may be imminent. This concern is reinforced by several economic indicators including the U.S. bond market’s recently inverted yield curve and a significant increase in the amount of international debt with negative yields. These unique circumstances require some explanation.
Inverted Yield Curve
The Federal Reserve controls short term interest rates and sets their target rate based on their interpretation of economic data and what they believe the economy needs to grow at a reasonable pace without excessive inflation. Typically, they lower rates when the economy slows and raise rates when we are in expansion mode. Other than overnight rates set by the Federal Reserve, bond yields are determined by the market itself. Typically, the longer the term of a bond, the higher the yield.
It is not uncommon that the Federal Reserve will be deemed too aggressive when raising rates. Bond yields often telegraph the markets expectations of inflation, economic growth, and even the Federal Reserve’s next decisions. Over the last 50 years, there has been a point in every economic expansion when longer-term bond yields have declined below the short-term rate set by the Federal Reserve. This is called an inverted yield curve and is essentially a market indicator that the Fed will reverse course and lower rates rather than raise them.
Some look at the history of inverted yield curves and conclude they are an accurate indicator of pending recessions. While the last seven recessions were preceded by inverted yield curves as depicted in the chart below, they cannot be used to accurately predict when a recession will happen. In fact, according to Credit Suisse, the average gap between yield curve inversion and actual recession is 22 months, with the longest gap being close to three years.
The Federal Reserve has already exhibited their adaptability by lowering their short-term interest rates twice. Given that they have reversed course on tightening, and the yield curve is no longer inverted, this economic indicator may prove to be an exception to the rule.
Negative Interest Rates
Outside of the U.S., there are a significant amount of bonds trading with negative yields. It is somewhat crazy that an investor would loan $105 to Germany with the expectation of getting $100 back in 10 years.
That said, the math of international bonds can be complicated. According to a recent article in Forbes, if a U.S. investor purchased that same 10-year German Bund and put in place a currency hedge between the Dollar and the Euro, the resulting yield would be closer to 2%, making German Bunds potentially more attractive to U.S. investors than U.S. Treasury bonds.
It is also worth noting that bonds trading at negative rates does not mean every investor is willing to accept those terms. It is the marginal buyer that is paying the price and the accepting the yield. An investor who bought a 30-year German Bund paying 4% twenty years ago is still getting their 4% yield even though that bond could be sold today at price that would reflect the negative interest rate.
Currency conversion rates, low growth and inflation expectations, and central bank policy all have an impact on the pricing of bonds and their current yield.
There is no question that growth is slowing, both in the U.S. and across the globe, but GDP growth has ebbed and flowed throughout this 10-year economic expansion and is likely to continue to do so. This may lead to a recession or a soft landing and recovery. Either way, recognizing that recessions can’t be timed makes having a solid financial plan with a long-term investment strategy the most important thing on which to focus.
In summary, Jamie Dimon, the CEO of JP Morgan was recently quoted in multiple news articles. The headlines read:
“Of course, there's a recession ahead.”
What the news outlets left out of the headline was the most important part of his comment:
“What we don’t know is if it’s going to happen soon.”
Zero Trading Fees……Is it True?
Recently, Schwab announced elimination of commissions when trading U.S. stocks, ETFs, and options (institutional mutual funds still have minor trading costs). Within days, the rest of the industry (TD Ameritrade, Interactive Brokers, E Trade, and Fidelity) matched zero trading fees. This is good news for investors.
While articles and full-page ads by these brokerage firms (also known as custodians) make this look like a win for consumers, nothing is truly free. The major brokerage firms have billions in annual revenue that comes from somewhere and while it may look like their services are cheap, they can be expensive if not managed properly. Some sources of revenue are hidden from clients and our job is to manage the relationship with custodians on behalf of clients to make sure they pay fair prices for their services.
One hidden source of revenue includes fees paid by mutual fund companies to be available on the custodians’ platforms. The mutual funds that pay these platform fees can be bought and sold with no transaction fee and often wind up on the custodians’ recommended lists. Institutional fund companies that refuse to share revenue with the custodians (DFA, Vanguard and others) require small trading fees when bought or sold. The net cost of institutional funds with small trading fees are generally significantly lower than the “No Transaction Fee Funds” that charge higher fees and pay the custodians a portion of their revenue. We select low cost institutional funds and trade efficiently to ensure that our clients’ costs are as low as possible.
Another significant source of revenue for most of the large custodians comes from what they earn on cash holdings. As an example, one custodian currently pays a yield on cash of 0.1%, as they are likely earning significantly more and pocketing the difference. Remarkably, this cash disparity between what they earn and what they pay amounts to approximately 50% of their $10B annual revenue. Thankfully, they offer money market funds that pay significantly higher rates (1.7%) but require a bit more work on our end as they need to be bought and sold like a mutual fund. Our goal is to manage clients’ cash efficiently, by either keeping accounts fully invested with minimal cash reserves or using money market funds and other higher yield holdings to maximize the rate of return when a cash reserve is needed.
Every independent investment advisor needs to work with a custodian to provide brokerage services to clients. We have a good partnership with our custodians and consider them to be best in the industry. That said, we must proactively manage that relationship and always ensure clients are getting the best service for the best price.