Commentary - Emerald Connect
Commentary December 2016
Fixed Income Market Post-Election Update: Keep Calm and Clip Your Coupons
Bond markets took a hit as yields rose in response to expected Trump policies. Stock prices are sitting near record highs. While nervous investors are thinking about selling bonds, bonds play an important role in many portfolios.
U.S. financial markets have reacted swiftly following the surprising results of the Presidential election. Equities have reacted positively as campaign promises of fiscal stimulus and tax cuts should provide a backdrop for stronger economic growth – at least domestically. Fixed income markets have responded quite differently with lower prices and correspondingly higher yields, as seen in Exhibit 1. Those same campaign promises are likely to be inflationary and potentially will make the Federal Reserve (Fed) move to hike interest rates more than it would have otherwise. These views have also led to a stronger U.S. dollar. Despite highs and lows for bonds in 2016, we’re mostly back to where we started the year with long-term investors having essentially earned their coupon rate this year. Exhibit 1: 10-Year U.S. Treasury Bond Yields 2.50
Yield (%)
2.25
2.00
1.75
1.50
The inflation trend has been gradually moving higher. This in and of itself would imply that yields and interest rates should be moving higher. Proposed fiscal stimulus should be net expansionary, perhaps adding 0.5% to 1.5% to GDP over the next two to three years, and likely inflationary, which has led to sharply higher yields. During the course of 2016, Treasury bond yields have seen both a dramatic fall and a dramatic rise and wound up essentially where they began the year. The yield on 10-year Treasurys bottomed around 1.40% amid concerns over weaker global growth, deflation, and the impacts of Brexit. Our view, at the time, was that safety assets had become rather expensive. With this latest move, Treasury bond yields appear to be closer to a fair reflection of economic fundamentals. Given the pace of the adjustment, however, we wouldn’t be surprised to see some retracement and further repricing as the market digests new information and reassesses the impact of the incoming President’s policies. What is SEI’s short-to-medium term view for the 10Year U.S. Treasury bond yield? Over the next 12 to 24 months, we would expect the yield for 10-year Treasurys to be generally range bound between 2% to 3%. We’d caveat that with a major negative shock to financials markets could result in investors fleeing to safer assets and a yield below 2% for the 10-year Treasury. How will the Fed react?
Source: U.S. Department of Treasury
Why have yields moved so quickly? Economic data was already pretty strong. The U.S. is at full employment (an unemployment rate at or below 5%). Third quarter gross domestic product (GDP) growth was recently revised upward to 3.2%.
© 2016 SEI
Even before the election we were already expecting a 0.25% interest rate hike from the Fed in December followed up by a gradual hiking cycle that would likely include two hikes in 2017 (see Exhibit 2). Expectations for December remain intact; however, if the current market view of the reflationary impact of fiscal policy proves correct, the Fed will likely be forced to speed up its hiking cycle or risk falling behind the curve on inflation.
Exhibit 2: The Fed “Dot Plot”
How are SEI’s fixed income funds positioned?
4.00
Our U.S. core fixed income funds are essentially neutral with regards to duration and have a modest yield curve flattening bias that was reduced after the election through duration positioning. Managers in the core fixed income funds selectively increased duration in the middle portion of the yield curve (five-year and 10- to 20year) but reduced duration in the one- to three-year and 30-year portions. The net result was to slightly increase overall duration to its current neutral position. An overweight to investment-grade credit has performed reasonably well, and managers have added to financials as a relative value position with expectations that higher rates will help net interest margins.
Federal Funds Target (%)
3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00
2016
2017
2018
2019
Longer Run
Source: Federal Open Market Committee as of 9/21/16. Note: Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant’s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer-run projections.
Should investors continue to hold fixed income in their portfolios? In a word, yes. SEI believes that from a long-term, strategic perspective, establishing the appropriate policy portfolio sets the foundation for achieving investors’ goals and objectives. We also believe there are shorterterm opportunities to improve risk-adjusted returns, but it’s important to clearly distinguish between these two perspectives. Diversification helps to reduce volatility, but that also means holding asset classes that may not be in favor at a given time. Fixed income is an important component of volatility reduction and loss mitigation in times of financial market distress. By definition, a truly diversified portfolio will underperform the best performing asset class over short periods (right now this is stocks which are sitting near all-time highs), but investors will generally reap the benefits of diversification over longer time periods. SEI is not considering any strategic (longterm) allocations changes to its portfolios as a result of the election.
© 2016 SEI
High-yield positioning has not changed and the asset class has held up better in the post-election environment than investment-grade bonds. Within high yield, an allocation to CLOs remains the largest active position, underweights to basic industry, telecommunications, capital goods and financials remain, and we have retained an overweight to technology and electronics. Within emerging-markets debt, an overweight to local currency debt hurt; this was especially true in Mexico as the peso plunged over more stringent immigration policies and the possibility of renegotiated free trade deals – we don’t believe NAFTA (North American Free Trade Agreement) will be scrapped. The supply chains for North American economies have become too integrated, and Mexico has already expressed a willingness to “modernize” NAFTA. Managers have been tactically trading local currency positions since the election as opportunities present themselves. There is still a lot of uncertainty as to how policies will eventually take shape. Municipal bonds have struggled more than other bonds due to a confluence of events. Issuance has been strong issuers anticipated rising rates and sought to lock in better deals. Proposed tax cuts could make the tax advantages of municipals less attractive. With year-todate performance now turning negative there is also the possibility for more year-end tax-loss selling given the tax-sensitivity for most municipal bond investors. Shortterm headwinds could get worse before they get better, but longer term these issues are less concerning.
2
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. Diversification may not protect against market risk. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. There is no guarantee that the Fund’s income will be exempt from federal or state income taxes or the federal alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Bonds and bond funds will decrease in value as interest rates rise. For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SEI Investments Management Corporation (SIMC) is the adviser to the SEI funds, which are distributed by SEI Investments Distribution Co (SIDCo). SIMC and SIDCo are wholly owned subsidiaries of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor. To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-800-DIAL-SEI. Read it carefully before investing. This material is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security. There are risks involved with investing, including loss of principal. Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.
© 2016 SEI
3
Fixed Income Market Post-Election Update: Keep Calm and Clip Your Coupons
Bond markets took a hit as yields rose in response to expected Trump policies. Stock prices are sitting near record highs. While nervous investors are thinking about selling bonds, bonds play an important role in many portfolios.
U.S. financial markets have reacted swiftly following the surprising results of the Presidential election. Equities have reacted positively as campaign promises of fiscal stimulus and tax cuts should provide a backdrop for stronger economic growth – at least domestically. Fixed income markets have responded quite differently with lower prices and correspondingly higher yields, as seen in Exhibit 1. Those same campaign promises are likely to be inflationary and potentially will make the Federal Reserve (Fed) move to hike interest rates more than it would have otherwise. These views have also led to a stronger U.S. dollar. Despite highs and lows for bonds in 2016, we’re mostly back to where we started the year with long-term investors having essentially earned their coupon rate this year. Exhibit 1: 10-Year U.S. Treasury Bond Yields 2.50
Yield (%)
2.25
2.00
1.75
1.50
The inflation trend has been gradually moving higher. This in and of itself would imply that yields and interest rates should be moving higher. Proposed fiscal stimulus should be net expansionary, perhaps adding 0.5% to 1.5% to GDP over the next two to three years, and likely inflationary, which has led to sharply higher yields. During the course of 2016, Treasury bond yields have seen both a dramatic fall and a dramatic rise and wound up essentially where they began the year. The yield on 10-year Treasurys bottomed around 1.40% amid concerns over weaker global growth, deflation, and the impacts of Brexit. Our view, at the time, was that safety assets had become rather expensive. With this latest move, Treasury bond yields appear to be closer to a fair reflection of economic fundamentals. Given the pace of the adjustment, however, we wouldn’t be surprised to see some retracement and further repricing as the market digests new information and reassesses the impact of the incoming President’s policies. What is SEI’s short-to-medium term view for the 10Year U.S. Treasury bond yield? Over the next 12 to 24 months, we would expect the yield for 10-year Treasurys to be generally range bound between 2% to 3%. We’d caveat that with a major negative shock to financials markets could result in investors fleeing to safer assets and a yield below 2% for the 10-year Treasury. How will the Fed react?
Source: U.S. Department of Treasury
Why have yields moved so quickly? Economic data was already pretty strong. The U.S. is at full employment (an unemployment rate at or below 5%). Third quarter gross domestic product (GDP) growth was recently revised upward to 3.2%.
© 2016 SEI
Even before the election we were already expecting a 0.25% interest rate hike from the Fed in December followed up by a gradual hiking cycle that would likely include two hikes in 2017 (see Exhibit 2). Expectations for December remain intact; however, if the current market view of the reflationary impact of fiscal policy proves correct, the Fed will likely be forced to speed up its hiking cycle or risk falling behind the curve on inflation.
Exhibit 2: The Fed “Dot Plot”
How are SEI’s fixed income funds positioned?
4.00
Our U.S. core fixed income funds are essentially neutral with regards to duration and have a modest yield curve flattening bias that was reduced after the election through duration positioning. Managers in the core fixed income funds selectively increased duration in the middle portion of the yield curve (five-year and 10- to 20year) but reduced duration in the one- to three-year and 30-year portions. The net result was to slightly increase overall duration to its current neutral position. An overweight to investment-grade credit has performed reasonably well, and managers have added to financials as a relative value position with expectations that higher rates will help net interest margins.
Federal Funds Target (%)
3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00
2016
2017
2018
2019
Longer Run
Source: Federal Open Market Committee as of 9/21/16. Note: Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant’s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer-run projections.
Should investors continue to hold fixed income in their portfolios? In a word, yes. SEI believes that from a long-term, strategic perspective, establishing the appropriate policy portfolio sets the foundation for achieving investors’ goals and objectives. We also believe there are shorterterm opportunities to improve risk-adjusted returns, but it’s important to clearly distinguish between these two perspectives. Diversification helps to reduce volatility, but that also means holding asset classes that may not be in favor at a given time. Fixed income is an important component of volatility reduction and loss mitigation in times of financial market distress. By definition, a truly diversified portfolio will underperform the best performing asset class over short periods (right now this is stocks which are sitting near all-time highs), but investors will generally reap the benefits of diversification over longer time periods. SEI is not considering any strategic (longterm) allocations changes to its portfolios as a result of the election.
© 2016 SEI
High-yield positioning has not changed and the asset class has held up better in the post-election environment than investment-grade bonds. Within high yield, an allocation to CLOs remains the largest active position, underweights to basic industry, telecommunications, capital goods and financials remain, and we have retained an overweight to technology and electronics. Within emerging-markets debt, an overweight to local currency debt hurt; this was especially true in Mexico as the peso plunged over more stringent immigration policies and the possibility of renegotiated free trade deals – we don’t believe NAFTA (North American Free Trade Agreement) will be scrapped. The supply chains for North American economies have become too integrated, and Mexico has already expressed a willingness to “modernize” NAFTA. Managers have been tactically trading local currency positions since the election as opportunities present themselves. There is still a lot of uncertainty as to how policies will eventually take shape. Municipal bonds have struggled more than other bonds due to a confluence of events. Issuance has been strong issuers anticipated rising rates and sought to lock in better deals. Proposed tax cuts could make the tax advantages of municipals less attractive. With year-todate performance now turning negative there is also the possibility for more year-end tax-loss selling given the tax-sensitivity for most municipal bond investors. Shortterm headwinds could get worse before they get better, but longer term these issues are less concerning.
2
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. Diversification may not protect against market risk. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. There is no guarantee that the Fund’s income will be exempt from federal or state income taxes or the federal alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Bonds and bond funds will decrease in value as interest rates rise. For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SEI Investments Management Corporation (SIMC) is the adviser to the SEI funds, which are distributed by SEI Investments Distribution Co (SIDCo). SIMC and SIDCo are wholly owned subsidiaries of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor. To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-800-DIAL-SEI. Read it carefully before investing. This material is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security. There are risks involved with investing, including loss of principal. Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.
© 2016 SEI
3
