Quarterly commentary: April 2015

At the close of the first quarter, the global economy continued to muddle along, with falling commodity prices, foreign currency weakness, and lower bond yields present throughout most of the world. The European Central Bank’s strategy to revive Europe’s economic malaise with the introductioncompass-money of its own brand of quantitative easing is in full swing. The U.S. remains a leader in the global economy, but first quarter economic measures have been mixed. While U.S. labor market gains were solid and headline unemployment fell to 5.5% (a new five-year low), the strong U.S. dollar and the resulting softening in global demand created headwinds for exports and multinational profits. Further, lower oil prices are causing layoffs and reductions in capital spending in the energy sector, reversing its role as the single largest catalyst for U.S. economic growth over the past five years. These headwinds will hopefully be offset by dollar strength and lower oil prices bolstering consumer sentiment, which should result in a subsequent boost to consumer spending.

As we have demonstrated, history clearly shows that asset classes rotate their leadership over time, as forces shift and economic cycles ebb and flow around the globe. The recent leadership of U.S. equity performance, especially large company stocks, is causing some investors to shy away from the relatively good value in many of the non-US markets. In the first quarter, we may have seen the beginning of this inevitable rotation as non-US developed markets handily outperformed the S&P 500. For the quarter, the S&P 500 was up .95%, while MSCI World ex USA Index was up 3.96% net of currency adjustments from the rising dollar. Emerging markets continued to trail, but finished up modestly with the MSCI Emerging Markets Index up .43%. Despite mounting speculation that the Fed will be raising rates soon, the global interest rate environment caused rates to fall in the U.S. and abroad, resulting in a modest gain in the Barclays U.S. Aggregate Bond Index for the quarter. We generally do not mention commodity prices, but found it noteworthy, in the context of oil prices and low inflation, to highlight the 5.94% decline in the Bloomberg Commodity Total Return Index for the quarter.

In our last commentary, we discussed recent dynamics in the eurozone and the sudden collapse of oil prices. We did so within the framework of the highly complex global economic and political environment in which we live. In that same vein, we would like to focus on another issue on the world stage that has our attention, and that is the state of global interest rates and the ramifications to us and the rest of the world.

For every action there is an equal and opposite reaction

We have spent significant time over the last few years discussing various aspects of the recent financial crisis, which caused governments and central banks to work individually and collectively toward global re-stabilization. Crisis or not, central bankers are continually at work determining what they feel is an percent-arrow-downappropriate short-term interest rate based on many factors, including the economic cycle, current levels of debt, inflation, employment, wage growth and a host of other factors.

However, the depth and breadth of the Great Recession caused central bankers to employ extraordinary measures outside of normal policy. This included lowering interest rates to zero, a policy referred to as ZIRP (zero interest rate policy), as well as, experiments like quantitative easing utilized for the first time in history. Any time policy of this magnitude is deployed, it invariably leads to excesses and unintended consequences. As such, we find ourselves in an interest rate environment where the U.S. has been at zero for six years, Japan at zero for far longer and many parts of Europe in negative interest rate territory (NIRP)!

The long road to ZIRP and now NIRP

Our current interest rate environment has been front page news for some time now, especially in light of these recent unprecedented moves. Yet, the dynamics that have ultimately led to this current situation have been developing for years. While central banks can set short-term rates, they have very little control over the scope of yields across the longer maturity spectrum. The following graph will give you a sense of the longer-term trend of interest rates.

So, if it is not the central banks, what has caused rates to fall to such low levels over such a long period of time?

In order to answer this question, one must understand the primary factors that influence the yield on any given bond. These primary factors are: credit risk, expectations of future inflation, expectations of the direction of short-term interest rates, and term (maturity) premiums.

NIRP? Really?

It is hard for us to imagine that the yield on almost one-third of the euro area’s $6.26 trillion of government bonds is now below zero! The entire global financial system is built on the supposition down-arrows-percent-2that borrowing costs are always above zero, but investors in European debt are currently willing to allow governments to borrow their money and pay them back less than they loan them. As an example, the Swiss government can now borrow $1,000 with no interest payments and return $994 to the bondholder in ten years.

Why would investors lock in a ten-year loss when they have a choice of shorter term maturities? Based on the explanation of bond yields above, the answer is that investors feel that deflation will persist, if not get worse, so they are betting they will lose more money by buying a series of one-year bonds over the next ten years.

What does this mean for the global economy?

bank-globeThe current interest rate environment continues to have a profound effect on the way capital is being deployed around the globe. Central bankers had hoped their stimulus would ultimately result in a resurgence in economic activity to spur real growth in our respective economies, thus raising corporate revenues and employing more people in a virtuous cycle. As this happened, central bankers could then begin to reverse this stimulus toward some semblance of monetary normalcy.

To some extent, these things are happening. Some businesses and individuals have taken the opportunity to refinance higher yielding debt, while others have used this cheap money to leverage new purchases in real estate, in capital equipment or for home improvement. Investors have been coaxed by these historically low rates into purchasing more risky assets such as junk bonds or equities in search of yield, despite their inherent risks. This flow of capital has helped stock prices rise, thus creating a wealth effect that in turn has spurred more investment and consumer spending.

Yet, on a fundamental level, the rate environment is also a profound statement as to the collective sentiment of individuals, companies and governments. And as always, significant moves like these are wrought with unintended consequences. Currently, the world believes that Eurozone has deflation in their future for a long time, a disturbing thought!


catch-22-image2a-webWhile governments certainly want their economies to improve, most of them, including the U.S., have record debt on their balance sheets that needs to be serviced. Lower rates mean low interest payments on debt, so governments and individuals will have more free cash flow for savings and spending. The Fed is well aware that when they raise rates, increased borrowing costs will reduce this free cash flow. As such, the Fed and other global central banks want to make sure economic activity is sufficiently robust so that the improvement in tax revenues from GDP growth and improved employment can offset the loss of this cash flow. This has proven to be very difficult, and some fear the Fed is caught in a trap of not being able to raise rates without causing things to quickly deteriorate.

In the Eurogroup, the single currency experiment has distorted normal market function among the member economies. In the global economy, currency and interest rate fluctuations allow the monetary system to arbitrate fiscal and economic imbalances. The problem in the Eurogroup is that everyone uses the same currency, but their economies are largely managed by their respective governments.

Therefore, the only tool available to resolve imbalances is interest rates, and it is simply not sufficient to use this in order to reach equilibrium. For instance, consider the imbalances that have been created between Germany and Greece. Germany has a robust economic engine and has benefited from the fact that their currency would have been far stronger than the Euro on its own. Conversely, Greece has an extremely inefficient economy and their currency, the drachma, would have been substantially lower to mitigate the imbalances. With interest rates the only tool available, Greece has been buried by punitive borrowing costs that would have been moderated by currency adjustments.

These historically low rates are also wreaking havoc on pension plans, insurance companies and short term investment instruments like money market funds. Insurance companies and pension plans are really “finance companies” whose entire structure is based on modeling reasonable returns in both the fixed income and equity markets to provide future payouts to pensioners and insurance claimants. With rates this low, it is next to impossible for them to match these liabilities to their ability to earn enough with reasonable portfolio risk to cover them, leaving them dangerously exposed. In the case of money market funds, with rates so low, they cannot even cover the cost of operating the funds, so fund companies have had to subsidize these instruments with millions of dollars to keep them available, another circumstance that simply cannot persist indefinitely.


Diversification in a complicated, uncertain world

Our strategy of constructing diversified global portfolios involves the science of determining assets with an expected rate of return and allocating them based on the relative movement between these asset classes over time. This is in the context of your individual circumstances, risk tolerance and time horizon.

It is equally important that these portfolios are also designed to acknowledge, but not be dependent on predicting the factors that will determine interest rates or currency valuation and equity movement. In our opinion, attempts to anticipate these movements are virtually impossible to do, especially with any regularity. We live in a complicated, unpredictable world, yet we remain confident that over the long run, we will be able to capture market returns regardless of short-term circumstances.

Stay the course!

Thank you for your continued confidence in our services.




Investment indices are provided by Standard and Poors, Russell Investments and MSCI. Performance of these indices is not indicative of any particular investment. The indices are unmanaged and individuals cannot invest directly in any index. The Barclays U.S. Aggregate Bond Index is comprised of a variety of taxable bonds, and is used as a measure, or benchmark, of the US bond market. No strategy including diversification can guarantee a profit in a down market. Past performance does not guarantee future results.

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