Monthly Market Insights – Bond Market Continues to Serve Up Short-Term Pain for Long-Term Gain

August 1, 2018

The stock market remains caught in a tug of war between politics and fundamentals. While trade tensions and the potential for additional tariffs suggest caution may be warranted, robust economic and profit growth continue to offer support to risk assets.  Gross domestic product jumped 4.1% in the second quarter, which was its best pace in nearly four years on a surge in consumer spending and business investing. Corporate profits have also been solid with approximately 85% of companies that have reported earnings beating earnings estimates. Of note, higher oil prices have provided support to energy sector earnings, while financials have benefitted from tax reform and higher interest rates.

For the month, the broad Russell 3000 Index, which is a measure of the performance of large and small cap domestic stocks, posted a return of 3.32%. In a reversal of trends, large cap value stocks slightly outpaced large cap growth stocks as technology stocks tumbled. Investors bailed out of the tech sector after Facebook announced a surprisingly weak growth forecast in their latest earnings report, and concerns mounted over how other tech stocks may fare amid rising interest rates. Facebook’s earnings report prompted the biggest market-cap decline in U.S. history with the stock plunging $119 billion in value. While tech tumbled, other parts of the market such as industrials attracted new money, which is a healthy sign because it shows that technology isn’t the only game in town.

Looking abroad, international developed market stocks posted positive returns with the MSCI EAFE returning 2.46% for the month and emerging markets returning 2.20%. Both indices remain negative year-to-date, but we believe the correction is reasonably advanced. Valuations overseas remain attractive relative to the U.S., and we expect a rebound in earnings both in Japan and many emerging markets. 

It has been a frustrating year for more conservative investors, and July provided no reprieve. The broad Barclays Aggregate Bond Index nudged higher a mere 0.02% on the month and was down 1.59% through the end of July. Interest rates rose steadily and hit the psychologically significant 3% level on August 1st. The pain of low bond returns is expected to continue, at least over the short-term, with the Federal Reserve signaling their intention to raise interest rates in September (bond prices typically fall as interest rates rise).

The low-return environment has led some of our clients to question the role of fixed income in portfolios. I wanted to take some time to address these concerns. By definition, a well-diversified portfolio of investments will contain some laggards during any given measurement period – especially over shorter-term periods. From a portfolio construction standpoint, it is important to focus on the overall portfolio and how the pieces fit together and complement one another over a range of economic and market scenarios. Successfully managing portfolios requires the discipline to resist trading out of (or into) an asset class based on emotions.

Statistically, the stock market experiences a decline of at least 10% once per year, on average. Bear markets (which are declines greater than 20%) tend to occur every seven years, on average. Fixed income plays an important role in a portfolio from a diversification perspective because it helps to buffer these declines, which are very difficult to predict in advance. Our portfolios are currently positioned to be slightly overweight stocks relative to bonds given our outlook for interest rates. However, we do not think it is prudent to reach much more into stocks at this point in the business cycle – especially given the backdrop of trade tensions.

Additionally, it is important to note that news about the bond market typically focuses on U.S. Treasuries, which tend to be the most sensitive to rising interest rates. In reality, the bond market is very diverse, and each sector or asset class responds differently to increases in the interest rates. Some fixed income asset classes, such as “floating rate” bonds, tend to perform well in a rising rate environment.  Over the last few quarters, we have diversified the fixed income portion of our LightPoint Portfolios to help hedge a rise in interest rates and are pleased to report that the majority of our fixed income managers have been able to provide returns in excess of the Barclays Aggregate Bond Index year-to-date.

Take heart that the short-term pain we are currently experiencing in fixed income is indeed for long-term gain. When interest rates move higher, bond prices typically fall; however, the level of yield investors receive when they reinvest the proceeds from maturing bonds or coupon payments is higher as well. Because of this, earning the yield and then reinvesting into higher yields over time can actually increasea bond portfolio’s overall return potential, and offset the initial negative price impact of rising rates. It just takes some time for this to work out mathematically.

Looking ahead, we believe the return environment for stocks will become more challenging. We are starting to see signs of weakness in the traditionally cyclical sectors of housing and autos.  While the economy looks set to continue to grow at a 3% pace through the middle of 2019, it is expected to decelerate in the latter half of next year due to fading fiscal stimulus. This will likely slow earnings growth alongside a continued rise in interest rates and provide pressure to the stock market. That said, the near-term environment remains supportive of equities broadly, and we will continue to position our portfolios as warranted based on our outlook.

Thank you for your continued confidence. Please reach out to us with any questions you may have.

-Hillary Sunderland, CFA®, CKA®

Chief Investment Officer for Beacon Wealth Consultants, Inc.

 

Index Returns

 

Year to Date

1 Year

3 Year Annlzd.

5 Year Annlzd.

Bloomberg Barclays Aggregate Bond Index

-1.59%

-0.80%

1.49%

2.25%

Bloomberg Barclays Global Aggregate Bond Index

-1.62%

-0.48%

2.45%

1.21%

Russell 3000 Index

6.64%

16.39%

12.18%

12.83%

MSCI ACWI ex-US Index

-1.46%

5.94%

6.00%

5.59%

Bloomberg Commodity Index

-2.14%

2.73%

-1.61%

-7.06%

Source: Morningstar® as of July 31, 2018

 

Disclosures

Financial Planning and Investment Advisory Services offered through Beacon Wealth Consultants, Inc., a Registered Investment Advisor.

The material has been prepared for informational purposes only and is not intended to provide, nor should it be relied upon for, accounting, legal, or tax advice. References to future returns are not promises or estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. Information and data referred to in this document has been compiled from various sources and has not been independently verified. We believe the information presented here to be reliable but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase of any financial instrument. The views and strategies described may not be suitable for all investors.

All returns represent total returns for the stated period. The Bloomberg Barclays Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. The S&P 500 Index is a market capitalization weighted and unmanaged group of securities considered to be representative of the stock market in general. The Russell 3000 Index is a market capitalization weighted index that measures the performance of the largest 3,000 companies representing approximately 98% of the investable U.S. equity market. The Russell 2000 Index is a market capitalization weighted index that measures the performance of the smallest 2,000 companies in the Russell 3000 Index. The MSCI ACWI ex-US Index is a market capitalization weighted index designed to provide a broad measure of equity market performance throughout the world and is comprised of stocks from both developed and emerging markets outside of the U.S. The Bloomberg Commodity Index is designed to be a highly liquid and diversified benchmark for commodity investments.

Past performance is not indicative of future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss. You cannot invest directly in an index.