One of the interesting aspects of the market this year is that the sectors that are doing best are not the ones an investor would naturally expect. For instance, the sector which is blowing away the S&P 500 is utilities. The stocks have been doing so well, they are showing up in momentum oriented funds, which is a rarity. The sector is known for its solidity and stable returns, but right now utilities are hot. Over the last twelve months, utilities have returned 21.2% versus the S&P 500’s 7.3%.
FINSUM: You don’t usually think of utilities getting hot, but because rates are falling at the same time as real estate weakening, utilities are taking a lot of capital that is usually split with REITs.
The bond market seems to have blind faith in the Fed right now. Longer-term bond yields have fallen dramatically, a sign that fixed income investors are sure the Fed is not planning any moves. Not only are bonds up considerably lately, but implied volatility is very low. That means investors are discounting both the chance for an inflation increase and an economic downturn. In other words, they think the economy and Fed is going to stay right where it is.
FINSUM: Can you blame them? The economy lingered in what we think of as an investor’s “goldilocks” phase for several years after the Crisis—inflation not too low, not too high, Fed on hold, asset prices rising. It does not seem unlikely we go back into that mode.
Right now might not seem like the most important time to buy rate-hedged or short duration funds. The Fed is supposed to be on “pause” after all. However, in our view, now might be a critical time to have some rate hedged assets in the portfolio. The reason why is that yields have pulled back strongly from just a couple of months ago, including yesterday, but given the fact that it is almost purely the Fed which has caused the sharp reversal, rates could swing just as wildly higher if their comments, or economic data, changes. In other words, the bond market looks overbought right now because of Fed comments, but it could easily snap back to where it was in December in violent fashion.
FINSUM: We think this is a time for caution on rates and yields given how strongly the market has reversed over the last couple of months.
Bloomberg has put out a very bearish article on the economy. The publication is arguing that there is a 2/3 chance of a recession beginning this year, and that a bear market is likely to happen alongside it. As evidence of the pending downturn, the article cites these as indicators: the nearly inverted yield curve, the big fall in stocks in Q4, weak housing activity, terrible February payrolls, and the fact that the rest of the world is slowing. One of the most acute worries though is that the Fed will keep hiking as part of an effort to leave itself room to cut rates in the next recession, an action which could drive the economy into a recession.
FINSUM: Again, much of the direction of assets and the economy depends on the Fed’s mindset. If the central bank returns to hiking, a recession looks like a sure thing. But if not, it is far from certain.
There are a lot of good reasons to own Treasuries right now, and a lot of reason to be nervous about them. Let’s take a look. The biggest risks in the market at present are mostly about the budget deficit, which makes Treasuries look weak and inflation likely to jump (as it has historically during such spending). However, there are a lot of positives too. The big one is that the Fed looks ever more likely to adopt a permanently dovish stance as it may be changing its thinking about inflation. Additionally, economic weakness will be bullish for Treasuries, so coming to the end of the cycle is not catastrophic.
FINSUM: The best place to be on the yield curve is clearly at the short end—less rate risk and decent yields.