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Market Perspectives - December 2017


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Market Perspectives - December 2017

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Market Perspectives - December 2017

  1. 1. Market Perspective – December 2017 Experience Insight Impact Overview: As 2017 comes to an end, with markets focused on Tax Reform (our topic next month), many investors are growing concerned with the flattening of the yield curve. History tells us that at times, the flattening of interest rates across maturities can be a harbinger of recessionary conditions. This month, we analyze both the current fixed income environment and what to monitor going forward in relation to the shape of the yield curve. 1
  2. 2. Yield Curve Defined Experience Insight Impact • The treasury yield curve is a line that plots interest rates at various points in maturity assuming equal credit quality. Most investors use treasury bonds as a proxy for this. • Traditionally, investors will require a higher yield to lend their capital for longer periods of time, thereby creating an upward sloping graphical view as shown at the right. Source: Bloomberg 2 Rate(in%) Time to Maturity
  3. 3. Why Does This Matter? Experience Insight Impact The vast majority of the time, the curve is upward sloping. Investors seek to be paid extra yield for the uncertainty of holding longer-dated securities (e.g. the risk of heightened inflation). However, there are several scenarios which cause consternation for investors: • Weakening Economy - Investors want the certainty of return if the economy weakens. This drives demand to longer-dated bonds, which reduces their rates. At the same time, demand for shorter- dated bonds declines, pushing their yields higher. This is what investors call a “flattening” of the yield curve. If economic conditions appear dire enough, then the curve may invert, meaning short maturity bonds offer a higher rate than longer maturity bonds.  Throughout history, markets have always viewed the inversion of the “yield curve” as a harbinger of recessions. • Strengthening Economy - As economic activity picks up steam, the Federal Reserve, with their mandate to keep prices stable, will raise rates to cool off an economy that looks inflationary. This may push short rates higher. • Currently, the concern is that over the last 12 months, short-term rates have risen and longer-term rates have fallen, which has led to a flattening yield curve as indicated on the following slide. 3
  4. 4. Yield Curve Concerns Reminder: The yield curve represents the yield earned by an investor for accepting different maturities. Typically, it takes a higher yield for an investor to accept a longer dated security. As the risk of recession grows, an inversion in the yield curve tends to signify the choking off of growth capital. Experience Insight Impact 4 • Since 12/31/16, the yield curve has undeniably flattened for a variety of reasons. (The green solid line is as of 12/11/17, and the yellow dotted line is as of 12/31/16.) • This year, short-term interest rates have risen, due at least in part to the Federal Reserve’s actions. • At the same time, longer- term rates have remained stubbornly low as inflation expectations remain largely contained. There are several other reasons creating demand for bonds at the long end. Source: Bloomberg
  5. 5. Shorter-Term Global Yields Remain Negative For Many Countries U.S. yields may be artificially low due to continued quantitative easing from around the world. The table above lists 2-year yields from countries around the globe, many of which are currently negative (see yellow). U.S. yields look more attractive relative to the global fixed income environment, thereby potentially skewing true fixed income demand and pricing. Experience Insight Impact 5 Source: Bloomberg
  6. 6. Yield Curve Concerns At the present time, the curve is not inverted. However, spreads between short-term and longer-term yields are the narrowest in a decade. The yield curve has inverted before all of the recessions in the last 50 years, although the exact timing remains inconsistent. For example, the first inversion from the 2008 financial crisis actually occurred in December 2005, several years ahead of the recession. Experience Insight Impact 6
  7. 7. Market Perspective – December 2017 Experience Insight Impact Conclusion: The past year has seen the yield curve flatten meaningfully, placing investors in a watchful waiting mode for the next moves. With an inversion being a relatively reliable indicator of recession, we understand the concern. At the present time, however, the curve remains comfortably upward sloping, and it must be recognized that this is simply one variable for investors to watch. Our eyes remain focused on a wide variety of evidence to support our investment stance, with the shape of the yield curve being one of those factors. 7
  8. 8. Disclaimer Experience Insight Impact Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy. 8