Author: ContentMigration

A perfect storm in the bond market just occurred as Hurricane Fed crossed paths with an Italian tropical storm and U.S. Dollar high pressure system. After hitting a high of 3.12% on 05/21/18, 10-year Treasury yields have fallen 25bps, touching a low of 2.76% yesterday. What’s driving this move? It’s a confluence of curve slope, U.S. Dollar strength, and Italian political strife. With this mix of factors, the Fed may find a neutral policy rate sooner than expected. Any reprieve from rate hikes would deliver much-needed rate stability and offer bond investors some upside for the balance of 2018.

The slope of the Treasury yield curve, or the difference between short and long rates, has been on the decline since the Fed began its current rate hike cycle. With the difference between 2-year and 10-year Treasuries at 45bps, the Fed is in danger of inverting the yield curve with three more hikes this year. In the past, inverted yield curves have preceded economic slowdowns. Rate hikes concurrent with balance sheet reduction could mean the Fed’s total policy mix moves past normalized and right into restrictive territory.  Numerous Fed presidents, including Kaplan, Bostic, and Bullard have offered hesitation over inverting the yield curve. Without a pickup in long-term yields, September and December rate hikes become questionable.

Another factor at play recently is the U.S. Dollar, which has rallied 6% since April. Strength in the U.S. Dollar creates headwinds for improved inflation. Dollar strength has also caused some consternation for international equity investors, with emerging markets (EM) down 5.9% since the dollar began its rally in April. Policy hikes supporting additional dollar strength puts the Fed at risk of amplifying downward pressure on U.S. inflation, raising the local currency cost of U.S. Dollar-denominated EM debt, and increasing concerns of a policy overshoot.

Italian political infighting and discord has caused a move higher in Italian bond yields and risks another Eurozone crisis. In case you weren’t looking, Italian 2-year government bonds rose 1.83% yesterday to close at 2.70%, setting up another battle between Germany and the Eurozone’s southern region. While this one will likely be resolved as others have, with the Eurozone surviving, the pain to arrive at an agreement will be unpleasant and unsupportive of European economic growth. This matters because the ECB will have little appetite for QE tapering if Italy becomes a problem.

Ultimately, the upward ascent of U.S. bonds yields is running into resistance.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value.  Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Interest rates have increased dramatically since the end of 2017 and are expected to continue climbing. How can fixed income investors insulate themselves from inherent risks while taking advantage of the opportunities presented by this change in market dynamics? At Sage, we believe the best course of action is to make a strategic shift from fixed to floating rate bonds, which offer benefits that may not be so obvious to investors.

Market dynamics: Why rates will continue to rise

U.S. Treasury rates have increased for both fundamental and technical reasons, including commodity price increases, labor market tightening, and the Fed’s shrinking balance sheet.

Inflation expectations have in shot up in recent months due to an increase in commodity prices and tightening labor market conditions. With unemployment in the U.S. now below 4%, labor has become scarce, and thus wages should increase. The chart below shows the breakeven rates on Treasury inflation-protected securities (TIPS), used as a proxy for inflation expectations, which are on the rise.

Various geopolitical factors, including conflict with Iran, poor oil production performance from the leftist government in Venezuela, and increased global demand for liquefied petroleum products has caused the price of oil to increase dramatically in 2018.

In addition to these fundamental shifts, there is a large technical factor driving Treasury rates higher. The U.S. Federal Reserve’s Federal Open Market Committee (FOMC) has begun to shrink its balance sheet, allowing up to $10 billion of Treasuries and mortgages to “roll off” each month rather than reinvesting in those markets. The FOMC has been one of the largest buyers of U.S. Treasuries and mortgages, but is paring down assets to $2.5 trillion from $4.5 trillion at the peak. We anticipate that net global quantitative easing, used to support fixed income markets, will become negative by October, as the European Central Bank and the Bank of Japan also decrease their balance sheets.

What should fixed income investors do in a rising rate environment?

It may seem obvious that one would want to invest in floating rate bonds as interest rates increase, because rising rates will cause the coupons of floaters to rise in tandem with nominal rates, while fixed rate coupons will remain the same, causing the price of these bonds to decrease. But there is an additional benefit that may not be so obvious to most investors.

Floating rate asset-back securities (ABS), corporate bonds, and leveraged loans are all priced based on LIBOR, the London Interbank Offered Rate. This rate is set by a consortium of banks in the UK, and it is meant to represent the rate at which one bank would lend to another at various maturities. The ABS floaters generally price off the one-month LIBOR rate, while corporate securities generally use the three-month LIBOR rate as the benchmark. Because it is a rate of interest between banks, LIBOR has a credit component embedded along with pure interest rate considerations. As such, LIBOR rates tend to increase during periods of financial stress, while pure nominal interest rates tend to decline.

The chart below shows LIBOR versus the two-year U.S. Treasury. During the Dotcom Bubble, the Great Recession of 2008 and, to a lesser extent, during the European Debt Crisis of 2011, LIBOR increased while nominal rates decreased (as is typical in a “risk-off” environment).

This increase in LIBOR allows the coupon to increase to levels that will insulate bondholders somewhat from the dramatic spikes in both interest rates and credit spreads. The fixed income market has benefited from a prolonged low-spread and low-rate environment, but there’s reason to believe that may be coming to an end. As credit spreads increase concurrently with rising interest rates, we believe that floating rate bonds and loans are the best place for fixed income investors to achieve positive returns.

*Source on all charts is Bloomberg.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value.  Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Investors have long considered municipal bonds to be a way to invest in community-focused development, but measuring impact can be difficult. Until very recently, muni investors had to be content with having only a limited understanding of the nature, intensity, and duration of the financing’s impact at the local level. That changed in 2015 with the introduction of the United Nations Sustainable Development Goals 2030 (SDGs) framework.

The SDGs identified a global impact construct that offered investors a basis upon which to measure their investing. There are 17 core SDGs along with 169 performance sub-targets. The SDGs cover a broad range of social and economic development issues, including poverty, education, climate change, gender equality, sanitation, energy, environment, and social justice. The 169 sub-targets are used to measure progress toward reaching the target and ultimately accomplishing the stated core goal by 2030. This comprehensive framework allows organizations to align their projects with a broad global goal and have a measurable, target-based action plan to get there.

The United Nations Sustainable Development Goals 2030

(Source: United Nations)

The process for measuring ESG impact has become more standardized for publicly held companies, but ESG assessment tools have generally been unavailable and not often applied to municipal bond investing. Following the introduction of the UN’s SDGs, Sage developed a proprietary framework to evaluate the ESG impact associated with individual municipal investments. Through this framework, Sage first classifies each municipal entity within an issuer category or reference peer group. Then, after an in-depth review of the issuer’s relevant financial data and the entity’s ESG-related information, Sage assigns three scores: an overall ESG score, an impact score that evaluates the ESG-related relevancy of the project, and an impact intensity score that measures the magnitude of the project’s impact on the surrounding environment and/or community.

One of Sage’s municipal holdings is Aurora, Colorado, Water Revenue Bonds (5% due 8/1/2046 that are rated AA+/AA+). The proceeds are being used to fund the Prairie Waters Project, which will provide a sustainable long-term water supply under drought conditions to the city’s growing population. The project has resulted in more efficient utilization of water supply and has increased the availability of water by 20%. The project category is classified as Water Treatment, which would map to SDG 6, “Clean Water and Sanitation,” and SDG 11, “Sustainable Cities and Communities.”

Once Sage selects securities, the overall portfolio is evaluated in terms of its fundamental financial risk characteristics, i.e., credit quality, maturity, effective duration, and call features. In addition, the portfolio is evaluated in terms of its overall ESG risk characteristics relative to its historical trends, the level of anticipated community impact, and finally, the expected community impact intensity accruing from the projects represented within the portfolio.

Each month, Sage produces a report for each client invested in our ESG strategy. The report illustrates general holdings and security characteristics, in addition to offering a broader context to better understand local ESG impact levels and global SDG alignment at both the individual security and portfolio levels. These monthly reports enable ESG investors to know on an ongoing basis if they are making the right decisions as they strive for a better “double bottom line.”

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

At the dawn of the Trump administration a little over a year ago, equity investors were both hopeful and anxious. Hopeful for tax cuts and increased infrastructure spending, and anxious given of the potential for protectionist trade policy. On one hand, fiscal stimulus lifts growth and growth-oriented financial assets, while protectionist trade policies lead to higher costs and lower corporate profit margins, lowering economic growth in the process.

The administration is trying to deliver on both counts. Fiscal stimulus materialized in the form of tax cuts last year, and the recent proposal of substantial steel and aluminum tariffs have sparked trade tensions and spurred market volatility.

How should investors think about tariffs, and how could they affect markets? Here are 3 questions to consider:

How do Tariffs affect growth?

Tariffs have a negative effect on the growth of the countries imposing the tariff as well as the countries they are imposed upon.

Most simply, a tariff is a tax on an imported good, and by raising the price of a good produced overseas, the country enacting the tariff hopes to increase the attractiveness of a domestic good or industry, protect national security of strategically vital industries, or retaliate to another country’s tariff.

There is a benefit for the domestic producer of the tariffed good in lower competition and increased prices; however, the cost to the larger economy far outweighs the benefits. In the case of US companies that utilize steel and aluminum as inputs into their production, those input costs then rise and affect corporate profitability which spreads into the larger economy. The country which the tariff is imposed upon experiences a negative effect on its growth due to lower demand for its goods. That country could then initiate its own tariffs as a retaliatory measure, which reinitiates this dynamic of a negative hit to growth and could spiral into a trade war.

The US makes the first move, where do we go from here?

The signaling effect of the trade restrictions and potential retaliation are more impactful at this point than the economic effect. Steel and aluminum imports account for less than 2% of total US imports, and retaliation from trading partners have largely been symbolic and political. For example, the European Union have threatened retaliatory tariffs on Harley Davidson (headquartered in Milwaukee, Wisconsin, House Speaker Paul Ryan’s home state), Kentucky bourbon (Senate Majority Leader Mitch McConnell’s home state), and Levi’s jeans (headquartered in San Francisco, House Minority Leader Nancy Pelosi’s district). Things to watch will be:

• Continued NAFTA negotiations. Canada is the largest supplier of steel and aluminum in the US. How will the tariff affect NAFTA negotiations? President Trump has until April 1st to request an extension of a provision, the US Trade Promotion Authority (TPA), that is necessary to implement a renegotiation of NAFTA. That extension has to be approved by Congress, which means that Congress could have more of an influence in moderating the President’s trade stance.
• Signs of retaliation from partners in an economically significant way. Will the US or its trading partners escalate trade tensions? Does China retaliate with a tariff on Soybeans- or in a more extreme fashion, does China slow its purchases of US Treasuries?

Further escalation would heighten negative sentiment and increase the probability of a global slowdown. We are only the in the beginning stages.

What do investors do if tensions escalate?

The past 18 months have been marked by synchronous global growth and rising inflation expectations. The specter of a trade war threatens to reverse that trend of inflation to deflation. Diversification will be important. In an inflation scare, such as in February 2018, bonds and equities under-perform at the same time. In an equity sell-off driven by fears of deflation, fixed income should resume its role as a diversifier to balanced portfolios.

Within equities, relative fiscal and monetary conditions are key factors to consider. Since a tariff is effectively a transfer of wealth from the private sector to the public sector, the US stands to benefit the most since it is the only major country that has enacted fiscal stimulus in earnest. In terms of monetary policy, most global central banks have moved to normalize policy except for Japan, which has not signaled its desire to tighten. In isolation, relative monetary conditions favor Japan, but investors will have to weigh the country’s status as an export-driven economy and whether they will be exempt from future US tariffs.

Nonetheless, there are many more developments still to come in the current global trade saga. For investors, this year is shaping up to be a volatile one and will often require asking the right questions to prepare for when the answers emerge.

This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

On Monday, February 5^th the US equity market experienced its first 5% drawdown in 405 days. Three days later equities reached a 10% drawdown, which hadn’t occurred in almost two years. Market participants are now processing this move in real-time. Experts stand on both sides of the spectrum – some calling for a further correction, while others advise to “buy the dip” as the move this week is being deemed to be detached from fundamentals.

So why is this happening? In our view, there is no single cause, but a confluence of circumstances and events. Crowded positioning and bullish sentiment laid the groundwork. And, while economic growth and corporate fundamentals are strong, valuations fully reflect the underlying positive conditions. Here are the key events over the past two weeks that have stirred up market volatility:

• Bond yields rose after the US Treasury announced increased bond issuance on January 31^st in response to a larger budget deficit. In addition, the current administration’s announced plans for increased defense and infrastructure spending are expected to result in even more Treasuries issuance.
• Wage data released last week surprised to the upside giving rise to fears of an overheating economy in which inflationary pressures may drive central banks to tighten financial conditions further and slow the current growth cycle.
• On February 5^th, the VIX index spiked 20 points which is the sharpest rise ever for the index. Many investors, especially those with strategies linked to volatility, were caught off-sides and rushed to de-risk which exacerbated the correction throughout the week.

So what now? While we think technical selling ultimately subsides in the near-term, we believe that a period of higher volatility is here to stay. Below, we address the four most important questions for macro investors looking forward.

• Growth: How is the economy doing? Amid this month’s turmoil, economic data and corporate earnings continue to surprise to the upside. Tax reform should provide a boost to the corporate sector and consumption. The synchronous global growth conditions haven’t changed.
• Policy: Are central banks tightening or easing conditions? Central banks have taken notice of the strong economy, and have increasingly adopted a tighter stance as conditions have improved. However, we do think that concerns around financial stability and increased Treasury issuance provide a counterbalance to central bank tightening. We have not yet seen a desire for policymakers to respond to recent market developments. It goes without saying that an exit from global QE will be tricky. No matter your age, no one has experienced an exit from QE of this scale.
• Valuation: What is the market’s pricing of economic conditions? Given growth conditions and policy expectations, we think valuations are key. Global equity valuations fully reflected the positive side of strong growth and a healthy corporate sector. The markets are now adjusting to the reality of balancing the downside of strong growth and the end of QE. The rates market has priced in three rate hikes for 2018, and nearly two for 2019. The market is fully expecting the Fed to reach its rate targets.
• Sentiment: What is the prevailing market psychology? Market participants were euphoric in January, and after the recent move, sentiment has reverted to a normal level. January saw the largest inflows ever into equity ETFs (+$62 billion) and February is now seeing the largest equity ETF outflow on record ($30+ billion). The American Association of Individual Investors survey signaled extremely bullish sentiment in January. This week’s report showed a drop in sentiment back to more normal levels.

Undoubtedly, we know this year will not be like the last, where virtually all markets moved higher with little volatility. We’ll continue to assess the macro developments through our framework of Growth, Policy, Valuation, and Sentiment. This framework should serve our clients well in navigating the volatility ahead.

Source: Bloomberg. This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Technical indicators can be a useful tool for bond managers, particularly when combined with traditional fundamental/valuation methods and good old fashion macro research. In this piece, we address what the technical indicators are telling us about the potential path of the 10-Year Treasury yield.

From a technical perspective, the 10-Year Treasury yield is testing the three-decade long secular bull market resistant trend line of 2.63%.  Barring another false breakout, a break of 2.63% would put yields in a technical gap that could move yields up to a 3.00% very quickly. In this environment, diversification and active management are the keys to success for bond investors.

The chart below illustrates that the long-term trend line of 2.63% (orange line) is close to intersecting the Fibonacci resistant level of around 2.61% (grey line). Fibonacci levels tend to be well respected support/resistant areas where a break-out occurs or serve as the proverbial line-in-sand that does not get crossed. Historically, once the trendline is broken though, a reversal pattern becomes a higher probability event.

Although a trend change in the 10-Year Treasury yield may sound frightening to bond investors, the technical charts provide a well contained, and range-bound, move in the 10-Year yield if the long-term resistant level is broken.  If broken, the 3.00% level is not only supported, but also coincides with where the 5-year average real rate indicator suggests the 10-year rate should be.

As referenced in the chart below, although a sharp rise of the 10-Year Treasury has historically exhibited negative performance for the 10-Year Treasury, a well-diversified portfolio of bonds, as represented by the Barclays Aggregate Index, has performed quite well in those environments.

Additionally, active management through duration tilting and curve positioning are tools to limit, or even benefit from, the effects of rising rates. In addition, prudently adding spread product can potentially offset a rise in rates as spreads tend to be more stable and offer addition interest income carry.  For Sage clients, one of the major benefits of active fixed income management continues to be adjusting portfolio characteristics to maximize returns in any interest rate environment.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

Several of the technical/sentiment indicators we monitor are suggesting equities may be getting stretched. One indicator in particular caught our eye. The American Association of Individual Investors Bullish/Bearish Sentiment (below) reached a multi-year high last week signaling extreme bullish sentiment toward equity markets among individual investors. The current reading is a standard deviation above the norm (on a 4-week moving avg. basis), suggesting investors have become too bullish and begging the question, are we in for a correction near-term?

We dug into what this level has meant in the past for investors, at least over the last 13 years. This level has been hit three times previously since 2005. In all cases markets experienced some volatility and small drawdowns ranging from 1%-6% at some point during the following three month. However, in all three cases the S&P 500 Index was higher three months later, by an average of 3.3%. Bottom line, we are likely to get a small/medium correction soon, but given the fundamental picture, it would not be the start of something larger.  And, if the correction is greater than 10%, we would likely consider it a good buying opportunity.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product.  Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage.  Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such.  All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions.  Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances.  All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals.  For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.