Since the beginning of the financial crisis, investors have operated under the assumption that the global economy had down-shifted with respect to potential growth. Specifically, that 1.5%-2.0% GDP growth was our lot in life for the foreseeable future. Over the last year that view, bolstered by stronger than expected economic performance, has shifted up. The Federal Reserve (Fed) has moved into a slow but steady rate normalization process, with three hikes last year and 3 more hikes expected this year. Also, the European Central Bank (ECB) is reducing its purchase and should be done by September. Throw in fiscal stimulus, in the form of tax reform and investors are reassessing their underlying economic assumptions and how those changes impact valuations in the bond and stock markets.
Equity valuations started the year at elevated levels and risk premiums (spreads) on investment grade and high yield corporate bonds are at or near historical lows. Movements in nearly all asset classes, be they currencies, fixed income or equities, exhibited subdued levels of volatility throughout 2017. In fact, the annualized year-by-year volatility on the S&P 500® Index was the lowest ever in 2017, at a mere 3.89%.
The probability of 2018 experiencing as little volatility as 2017 is small when looking at the markets from a historical perspective. Few things hold true in financial markets, but two that we can count on are: markets are mean reverting and trends last until they don’t. Normally, market reversals exhibit large amounts of volatility. If the markets do become more interesting in 2018, investors will have to decide if the old adage is a blessing or a curse.
A theme that persisted all year, and continued into the fourth quarter, was the flattening of the Treasury yield curve. The yield on the 10-year U.S. Treasury Bond less the two-year U.S. Treasury Bond ended the quarter at 52 basis points (bps) after starting the quarter at 85 bps. At the start of 2017, the difference was 125 bps.
The flattening of the yield curve was mostly a function of the Fed raising short-term interest rates three times during the year, while longer-maturity bond yields didn’t move much due to low inflation and foreign demand for the relatively high yields available here versus Europe and Japan. The two-year U.S. Treasury Bond ended the year near the highs for the year at 1.88% versus starting 2017 at 1.20%. The curve shifts drove large differences among performance across the yield curve. During the fourth quarter, the Bloomberg Barclays U.S. Intermediate Treasury Index returned -0.41% versus the Bloomberg Barclays U.S. Long Treasury Index returning 2.37%. This difference was even larger when looking at the entire year, with Intermediate Treasuries returning 1.14% and Long Treasuries returning 8.53%.
The divergence in bond returns by maturity is expected to continue given current market conditions. Current market expectations for the federal funds rate diverges slightly from what the Fed forecasts for the year ahead. Market participants are currently pricing only two increases in the federal funds rate while the Fed has stated an expectation for three rate hikes. If market expectations move towards the Fed’s, there is a real possibility of a flat or inverted yield curve by year-end unless inflation moves meaningfully higher. We expect that inflation will pick-up and that there will be a term premium in the Treasury market by next year-end.
For many insurance companies tax-exempt municipal bonds have historically made up a significant portion of their fixed income portfolio. This was advantageous due to their superior after-tax yields and low credit volatility when compare to corporate alternatives. The passage of the tax reform act late last year has fairly dramatically changed the relative value equation between tax-exempt bonds and taxable alternatives. Due to the reduced rate of taxation on income from taxable bonds, on an after tax basis, taxable alternatives (corporate bonds, taxable munis and agency mortgage-backed securities) are more attractive across the maturity spectrum. We expect this relationship to remain since individuals, who make up the majority of municipal buyers, will find these bonds attractive at these levels given their tax rates did not change dramatically. In most cases, it will make more sense to hold existing tax-exempt holdings and then reinvest into taxable bonds at maturity.
Looking forward we expect a return to more normal volatility levels in both the fixed income and equity markets as global central banks pull back from massive balance sheet expansion amid a synchronized uptick in global growth. Resultant higher rates will offer opportunities for insurance companies to see significant growth in investment income while putting a damper on equity performance versus the exceptional returns we have seen over the last couple of years. Defensive positioning with respect to duration and quality continue to be warranted as central banks continue to normalize and rates move up across the curve.
Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Madison Scottsdale is the Insurance Asset Management Division of Madison Investment Advisors, LLC © February 9, 2018.