As 2016 draws to a close in a little over a month, it is easy to look back and see how remarkable of a year this has been. Between a Trump presidency and the exit of Great Britain from the European Union, this was a year of surprises. Yet in a year of uncertainty, the markets have been largely stable for most of the year. So why talk about capital preservation when things are looking good? In the words of Warren Buffett, “Be fearful when others are greedy and greedy when others are fearful.”
The temptation when times are good is to cut anchor and let yourself be carried by the current flows of the market. We have seen this in the US during the last couple of weeks with a significant gain in risk assets such as small-cap stocks and a selloff in safe assets such as bonds. While we have been saying for quite a while now that the US economy is in better shape than most have given it credit for, it does not mean it is okay to lose track of portfolio discipline just because the market has rallied.
Bonds, in particular, have been a great example of the fear/greed cycle creating opportunity. The US bond market has fallen nearly 3% in the last month as the news cycle has shifted from the election to the economy. Economic data has been largely positive and a rate hike continues to be likely in December by the Federal Reserve. 3% may not seem like a large number but that is a significant move in the world of bonds especially in such a short time frame. While rising interest rates are a real concern, the bond market continues to offer enough diversity not to overreact. We still believe that bonds are core to portfolio construction and are still the best asset class to combine with stocks to temper volatility. However, that does not mean we blindly step into risk. Here are a few of the factors we consider in building the conservative parts of our portfolios.
Inflation, while modest, has been finally starting to stabilize in the US. Policy shifts could also add to inflation but we are still coming off an extended period of low inflation. With that in mind, money market and cash equivalents carry significant risk in the loss of purchasing power. Nominal returns are still essentially zero and real returns remain negative. While fixed-income assets do carry the risk of short-term losses, a diversified portfolio of bonds should still have a far better chance of positive real returns relative to cash over time.
One significant policy change to keep an eye on is the attempt to repatriate corporate assets from overseas by lowering the corporate tax rate. Even cash-rich companies like Apple have offered bonds to avoid taxes in previous years but if it becomes easier to access foreign earnings it could lower the supply of US corporate bonds for the next couple of years. This could offer some extra stability to the bond market in the face of rising interest rates as demand is unlikely to decrease.
Interest rates will remain in focus and bonds with excessive interest rate risk should be avoided given their low returns anyway. While a core bond portfolio carries a more muted duration, long-term bonds and in particular long-term treasuries carry significant enough risk to consider reducing for the time being. We have shifted to more corporate debt in our bond portfolio to help mitigate the interest rate risk with the understanding that we are instead taking credit risk in our portfolios.
Using these factors and keeping an eye on changing regulation as the new administration comes forward is essential in building a bond portfolio that keeps up with changing tides but does not lose its place as the anchor in your portfolio. Even with the market reversal, it is important to remember that bonds have still returned between 2-3% this year which is what we are expecting on average for the coming years.