Content provided by Joshua Jenkins, CFA, Portfolio Manager
Over the last year, currencies have been on the forefront of my mind, which is unusual. I’m not saying they are not important. In the short term, they definitely impact returns. Portfolio Manager Case Eichenberger recently wrote about that here. Over the long term, however, the impact of currency fluctuations tend to net out to zero. As long-term investors, we are generally comfortable taking on currency risk if the asset we are buying is priced attractively.
So, why have I been thinking about currencies so much? Well, my wife, Kirsten, and I were married this August, and immediately after the wedding we traveled to Europe for our honeymoon. While I may be a long-term investor, I am not a long-term honeymooner. Suffice it to say the recent dollar move definitely had an impact.
We did not choose Europe last fall specifically because the euro was trading at the weakest level to the dollar in 15 years, but believe me that fact did not go unnoticed by me. So, as I spent 2017 watching my trip becoming more and more expensive, it was painful. Fortunately, we locked in a substantial portion of the cost in April by prepaying for hotels and flights to various destinations in Europe. At least we were partially hedged.
(If you look closely, you can see me calculating how much more I had to pay for the gondola ride due to the euro rally. Just don’t tell Kirsten.)
The chart below provides some rough evidence that currency moves even out over time. During the last 50 years, rolling 12-month returns on the Dollar Spot Index (DXY) generally resemble a normal distribution with a return of 0.01% on average.
As Case’s blog pointed out, weakness in the dollar has provided a very nice tailwind for our international holdings at CLS this year. In addition, according to the table below from Ned Davis Research, when sentiment towards the dollar (red line) is as sour as it is today, the dollar typically continues to underperform to the tune of 5% to 8% per year. To put it another way, this tailwind may persist, and that should generally be a postive outcome for CLS portfolios.
So, if you are planning a trip overseas in the near future, some attention may be warranted. Perhaps hedging a portion of the expenditure ahead of time could be beneficial. Though I was better off having hedged, my experience tells me it does little to reduce the mental pain of the unhedged cost. For long-term investors, enjoy the tailwind while you have it. Just remember — honeymoons aside — the long-term impact of currency fluctuations doesn’t need to keep you up at night.
Content provided by Marc Pfeffer, Senior Portfolio Manager
I know many investors don’t follow the short-term Treasury market on a day-to-day basis. But, as someone who has followed the fixed income market for my entire career, which includes running money market funds, I know these securities are key components. During the summer months, the debt ceiling dilemma started to play havoc on short-term Treasury bills maturing in October. Why? The debt ceiling was set to expire at the end of September, and there was a possible, albeit very small, chance the U.S. would technically default by delaying payment due to politics.
Although I personally thought there was zero chance of this occurring, one still has to plan and appreciate the market was going to price in some of this uncertainty. With Congress on vacation through August, it looked like a resolution could only come in September. From September 1 to September 7, investors in these T-bills had been whipped into a frenzy. But a deal was finally struck Thursday afternoon as Congressional leaders and the president agreed to a three-month deal to raise the debt limit. The negotiated measure would suspend the ceiling through mid-December, essentially kicking the can down the road.
So now, we go from worrying about T-bills maturing in October to those maturing in December and early 2018. Until the debt ceiling is abolished, it will continue to wreak havoc from time to time on the short-term T-bill market.
Luckily, the U.S. has never been late on its debt payments, and hopefully it never will.
Content provided by Case Eichenberger, CIMA, Client Portfolio Manager
I’ve received a few thoughtful questions from advisors this week, and I’d like to address them as I believe they may be on the minds of many CLS clients.
If you have additional thoughts or questions, please reach out to me at 402-896-7004 or firstname.lastname@example.org.
Content provided by Kostya Etus, CFA, CLS Portfolio Manager
Let’s review some events that took place over the last year:
Considering all of this volatility, you might think financial markets had a terrible year. But take a look at 2016 performance of the most common broad asset classes:
All markets are up! And some by a lot. How can this be with all of 2016’s surprises?
So now comes the hard part. Coming up with just one reason to add to our “91 Reasons Why People Did NOT Invest in the Stock Market” marketing piece for 2016!
Content provided by Grant Engelbart, CFA, CAIA, CLS Portfolio Manager
Investors have been infatuated with the timing and pace of the Federal Reserve’s (Fed’s) plan to raise interest rates ever since rates were pinned at the zero bound in the midst of the financial crisis. Most of the rhetoric regarding interest rate hikes is negative, after all, who wants to “pay more” for money? These fears for financial assets are overblown, as we have mentioned before. Besides focusing on the negatives, what are some of the benefits of higher interest rates?
Remember when your bank account paid you interest? Slowly but surely, banks are starting to raise the amount they pay customers. Online savings accounts typically have a slower process for moving funds, but those who are willing to accept a little less liquidity can get around 1% in interest. The craziness of celebrating 1% interest aside, it isn’t easy to find products paying 1% with a government guarantee (FDIC insurance) and no principal fluctuation.
Most fears regarding rising interest rates are based on client’s bond holdings (which nearly all investors have, whether they know it or not). We have written extensively on how important bonds are to portfolios and why investors definitely should not abandon them. When investing in bonds – whether through ETFs, mutual funds, or direct bond ownership –there are interest payments and bond maturities that need to be reinvested. Reinvesting these at higher interest rates is beneficial, particularly as the starting interest rate on a bond is often the best predictor of its return.
Interest rates rarely rise in a sustainable way without a prior rise in inflation. The word inflation typically brings memories of the 1980s or stories about the Weimar Republic to mind; however, moderate inflation is typically a sign of a healthy economy. By definition, inflation implies rising prices and wages. The latest jobs report shows wages rising nearly 3% from December 2015 to December 2016, which is currently faster than CPI inflation in the U.S.
Investment vehicles that use derivatives, such as futures contracts, have to collateralize their exposure. This collateral is typically invested in short-term, safe instruments, such as T-bills. Rising interest rates benefit the collateral yield of a futures position. This is particularly beneficial to commodity investments through ETFs, which typically use futures contracts to gain that exposure. Not to mention, commodities are also a hedge against inflation, which as mentioned accompanies rising interest rates.
Interest rates are an integral part of an economic system that affect nearly everyone. Borrowing money at higher interest rates is not preferable, however, the slow expected rise in rates doesn’t have to be detrimental and can actually benefit segments of the economy and population.
Content provided by Scott Kubie, CFA, CLS Chief Investment Strategist
The recent short-term rally in global stock markets has boosted optimism towards equity investments. While always glad to see our clients benefiting from market increases, CLS portfolio managers continue to keep a vigilant eye on market risk. In addition to our Risk Budgeting Methodology, we also regularly identify specific risks of greatest concern. (You can follow our list of key concerns by reading our quarterly CLS Reference Guide or Monthly Perspectives.)
Currently, global debt levels trouble CLS more than any other specific risk. While the risks of the 2008 global financial crisis are in the past, the debt used to help spur the economy past the crisis remains. This post seeks to explore different ways global debt levels might slow stock market returns in 2017. Before exploring the details, keep in mind the previous sentence included the word “might.” While these risks will shape markets in 2017, the most likely outcome is global governments will muddle through and markets will rise.
High Government Debt to GDP
At this point in the economic cycle, moderate GDP growth should be eclipsing deficit growth, meaning government debt is becoming easier to service. Keep in mind, governments rarely pay down debt by running surpluses. Instead, GDP grows at a faster pace than the deficit. Assuming taxes grow proportionately with GDP, government debt becomes less burdensome. So debt levels are often measured as a percentage of GDP. The table below summarizes debt levels of some key countries.
Research shows that the when debt levels rise above 90%, concern about increased taxes, higher inflation, and regulation slow GDP growth by 1% per year. None of those changes benefit stock markets in the long-term. This thesis is hotly debated, but the slow U.S. recovery and anemic recoveries in Japan and Europe support the conclusion that high debts pose a risk for global economies.
Bank Debt Becomes Government Debt
While Italy’s debt levels are terrible, the table above understates them. Italy’s third largest bank, Monte dei Paschi, was recently taken over by the government. Analysts estimate 20% of the bank’s loans are not performing. That figure overwhelms any capital buffers and leaves the Italian taxpayer with $6 billion in losses to cover. Monte dei Paschi is likely the most problematic bank in Italy, but it isn’t the only one. Italy’s already large debt would be higher if the number included debts the country would likely absorb when recapitalizing banks.
China, whose public debt is only 17.7% of GDP, faces similar challenges. Chinese banks continue to roll over loans to companies rather than forcing restructuring. Many of the problem borrowers in China are state-owned enterprises (SOEs) and the government is loath to pull the plug on its own businesses. While 17.7% looks good, it is widely assumed that the government would step in and cover the problem loans if necessary, thus piling on more debt.
Borrowing in Dollars
The final debt challenge results from a mismatch between debt currencies and home currencies. Many emerging markets, needing capital from abroad, borrow it in U.S. dollars and service their debt by converting taxes paid in their home currencies to dollars. Since the dollar has been rising compared to most global currencies, supporting dollar-based debt has become a larger challenge.
Conversely, Japan continues to run a massive deficit without as much risk because it borrows from its own citizens in yen at very low interest rates. While its debt levels are massive, its risks aren’t as high as in some emerging market countries.
Even with these challenges, countries will most likely muddle through. While this piece focuses mostly on risk, should any of these countries make the right set of structural reforms, the risk factors above may drop and stock markets could rally. Remember, investing provides its greatest rewards for bearing risks that others don’t want to bear.
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice.