March was full of indications the investment environment is changing. No, we are not going back to the 1970’s of my childhood, although there may be some similarities. Nor the 1960’s when musician Bob Dylan wrote The Times They Are A-Changin’. We are however headed into an environment unlikely to provide as an enjoyable ride as the last four decades.
1. The period of ever increasing liquidity is likely over.
The effective Federal Funds Rate averaged 19.6% in June 1981 and declined to near zero in late 2008, remaining there for 7 years before the FOMC raised the target Fed Funds rate. The FOMC cut the target rate to near zero again in April 2020. It raised it by 25 bps last month to a range of 0.25% to 0.50%. More rate increases are on the way.
Ten year Treasury yields followed a similar path, declining from an all time high of 15.82% in September 1981 to 0.52% in August 2020, before rebounding to 2.32% at the end of March 2022.
Most importantly, the Federal Reserve kicked off its quantitative easing (QE) strategy in 2008. Via its ongoing purchases of US Treasuries and agency mortgage backed securities, along with an alphabet soup of programs in partnership with the US Treasury Department in 2008 and 2020, the Federal Reserve grew it balance sheet by $8 trillion dollars, at a rate of 17.5% per year over a period of 13.5 years.
In summary, the four decade trend of declining interest rates and the thirteen and half year trend of rapidly increasing liquidity is over. As liquidity growth moderates, asset prices will lose a major tailwind. Volatility will increase.
2. Treasuries remain a flight to quality asset, but their role as a diversifying asset in non-crisis situations is likely to erode going forward. They experienced their worst quarterly performance since 1973.
In March, interest rates continued their recent upward trend. Year to date, seven year Treasury yields have risen 96 bps, ten yield Treasury yields have risen 80 bps, and thirty year Treasury yields have risen 54 bps.
As a result, Treasury funds experienced sharp price declines. Year to date, the iShares 7-10 Year Treasury Bond ETF has declined over 6%. The iShares 20+ Year Treasury Bond ETF declined over 12% before finishing the month down over 10% year to date.
This chart shows the price performance of IEF (iShares 7-10 Year Treasury Bond ETF in blue) and TLT (iShares 20+ Year Treasury Bond ETF in red).
3. Gold will become increasingly attractive if the world economy reverts to low productivity and sustained inflation. Gold may be the only asset class that serves as an effective hedge against the erosion of both Treasuries as a portfolio diversifier and the USD as the world’s reserve currency.
Gold performed its role as a portfolio diversifier admirably in the first quarter. We acknowledge gold does not enhance economic productivity. In a world of continual progress and increasing productivity, equities are the best investment asset to compound wealth and outperform inflation. However, whenever the global economy takes a step or two backwards with regards to productivity, whether due to underinvestment, policymaker decisions. or geopolitical conflicts, gold shines. Now may be one of those periods.
This chart shows the price performance of GLD (SPDR Gold Trust in gold), TLT (iShares 20+ Year Treasury Bond ETF in red), SPX (the S&P 500 Index in dotted purple), EFA (iShares MSCI EAFE ETF in dotted orange), and EEM (iShares MSCI Emerging Markets ETF in dotted black).
In the near term, it is difficult to envision an alternative to the USD as the reserve currency for the global trade system and the global financial system. However, the recent US government decision to freeze Russia’s access to US dollars in the global banking system will spur not only Russia, but China and other emerging market countries to seek alternate ways to engage in trade that do not involve dependence of the US and European banking systems. Gold will not become the medium of exchange for trade, but it will likely to be used to help anchor alternative medium of exchange.
4. The Fed’s ability to maintain market liquidity and support economic growth will be constrained by inflation. Supply chain issues and high energy prices are particularly problematic.
As measured by the Consumer Price Index for All Urban Consumers, prices increased 7.9% year over year in February, the largest year over year increase since the mid 1980’s.
Inflation can be thought of as too much money chasing too few goods and services. The Federal Reserve can easily reduce the supply of money, but given the global supply chain challenges and current US labor market conditions, the Fed may have to dramatically tighten monetary policy to slay inflation.
5. The tailwinds of excess manufacturing capacity and an abundant, easily accessible supply of commodities, equipment, and labor are no more, until years of capital spending materialize or a recession occurs.
Years of underinvestment in oil exploration and production, combined with a slow but steady increase in global oil demand, have driven oil prices above $100 a barrel. This shortfall in supply cannot be easily rectified and high prices will remain for at least a couple of years. In the meantime, higher energy prices will reduce consumer disposable income, reduce manufacturer’s profitability, increase transportation costs, drive food prices higher, and take focus away from creative activities that drive innovation and increase total factor productivity .
Source: IEA
Global labor supply greatly benefited from China’s integration into the global economy. Over the last decade, labor costs have risen dramatically in China. Offshoring production is no longer as advantageous from a cost perspective, especially with rising transportation costs. The US labor market is also quite tight, with no near term demographic boost.
6. Globalization has stalled and may be reversing.
With the end of the Cold War in December 1991 and the integration of China into the world economy, global trade rapidly expanded, supported by a period of relative peace, economic treaties, new addressable markets for products and services, and comparative cost advantages in manufacturing.
Rising geopolitical tensions between the U.S. and China, the rising costs of China labor, rising global transportation costs, the recent pandemic, and the even more recent Russian invasion of Ukraine are leading to a reversal of globalization.
First, there is the cost and reliability advantage of moving supply chains closer to home. For instance, Mexican workers are often more productive and skilled than those in China, with labor costs that are now similar. Freight costs from Mexico are about a third of shipping from China. Mexico also has more trade agreements in place for duty-free access to countries all over the world. A pandemic induced global economic shutdown is easier to manage if critical supply is closer to home.
Second, having access to secure sources of energy, industrial commodities, and semiconductors is now paramount. The tensions with China are worrisome since over 50% of the world’s semiconductors are manufactured in Taiwan. The Russian-Ukraine conflict highlighted the Europe’s dependence on Russia for natural gas, coal, and several industrial commodities.
7. One thing won’t change. Credit spreads will mean revert. Credit risk will materialize, accompanied by a spike in credit spreads. And when nerves are frayed and fear has propagated, credit spreads will begin a gradual decline and eventually plateau for an extended period.
The 110 bps rise in high yield credit spreads from the beginning of the year until mid March caught our attention as it looked like a spike was brewing. Since then credit spreads have declined.
Even at the recent peak of high yield credit spreads in mid March, high credit spreads were well below prior peaks, indicating that despite the Fed beginning to drain liquidity, high and rising prices for many commodities, and the challenges posed by sanctions on Russia, credit conditions were not tight.
There will be more volatility ahead. Returns will likely be lower than investors have become accustomed to during the almost thirteen year bull market. Equity investors may even face another large drawdown. Now is the time to reassess your risk tolerance and ensure you have adopted an overall portfolio strategy that will help you stay invested no matter what happens in the future.