A tide in the affairs of men (Return to volatility #1)
Written by: Jonathan V. Bever
There is a tide in the affairs of men, which taken at the flood, leads on to fortune. Omitted, all the voyage of their life is bound in shallows and in miseries. On such a full sea are we now afloat. And we must take the current when it serves, or lose our ventures. ‘Julius Caesar’ (1599) act 4, sc.3, I.215
Navigating the waters of investments is difficult in the best of times. As we ride over and through the investment waters that come with each tide we look for the key identifiers of what push and pull investments. In other words, we are navigating the proverbial shoal waters of investments that potentially have significant risk and reward. An experienced ship's pilot can navigate through difficult waters. There are no shortcuts; it takes the experience that only time provides, which is the key to navigate hidden reefs and other potential threats. For example, the safety of fixed income investments has been secure for over 30 years, but is now becoming more difficult. Being tied to your success has brought us all into the wheelhouse in search of greater rewards. Enough nautical allegory.
Today we are seeing replicated threats that have presented themselves against the future rewards of your investments: understanding these, brings understanding and competence into our position.
As we have seen an increased period of elevated US stock market volatility, every investor is asking when the storm will pass? Trade tariff rhetoric with China, the Fed on a course to raise rates several times this year, bruised investor sentiment, steep increase in LIBOR, and a significant increase in the LIRBR OIS Spread (*3-month LIBOR spread to the USD Swap Overnight Indexed Swap: Bloomberg) has been climbing rapidly: all have added to the fears of risk asset investors.
See chart: The top line is the LIBOR OIS Spread. The bottom line is the S&P 500.
Chart Source: Bloomberg
This spread hasn’t been this high since 2007. This spread increased significantly from 2006 to 2007. It came down a little only to find a new high during this period. What followed of course was the most significant financial crisis of our lifetime.
To be clear, we are not expecting a repeat of the deflation that followed. Some argue the cost of capital will continue to climb while others argue it will hit a celling and thereby be followed by a recession. At this point I expect the cost of capital to continue to climb, and the economy to continue to be strong.
Let us remain rational while considering the tail wind and the head wind as we move toward our goal. First the tail wind: fundamentals of the economy are strong, such as low unemployment, a Fed confident they can raise rates without derailing the current strong trend, a normal yield curve, and earnings season proving to be strong. Now the head wind: deep down impulses of fear are not so easily abated as stocks break trend lines and are not climbing to new highs. Some argue that the increased cost of borrowing will potentially severely hurt over-leveraged companies. Giving credence to this concern can be found by considering the Libor spread, and the fact that rising rates by the Fed is a reduction in stimulus (it’s a bit like putting the brakes on to slow the economy, with the intent to solidify and create a steady, well based future economy). In addition, the 10-year treasury yield has gone from 4.256% 6/13/2008; 1.3685% 7/6/2016; 2.0507% on 9/8/2017 to 3.112% on 5/17/2018. In short, the cost of borrowing money is rising.
Chart Source: Bloomberg
Most investors understand that a flat or inverted yield curve is a harbinger of an economy which is slowing and an increased chance of a recession. At his point the curve is not flat or inverted. However, the US LIBOR OIS Spread which has been climbing.
While we are optimistic on the stock market there are many economic currents pulling in different directions, which suggest that volatility will continue. In conclusion: look for companies with strong balance sheets, and increasing dividends; keep bond durations short; and continue to monitor the economic developments.
LIBOR: defined by Investopedia:
LIBOR or ICE LIBOR is a benchmark rate, which some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.”
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing.