Cumberland Advisors Market Commentary – The Bond Conundrum and How to Manage

The past couple of weeks have been breathtaking for bond investors and observers of the bond market. The yield on the 30-year Treasury bond is now at a record low – it dipped under 2% this week – and the 10-year Treasury is not far off its record low of 1.36% set in July 2016 – the yield now sits at 1.53%. With a little more than two weeks gone in August, we have seen the 10-year drop 47 basis points and the 30-year 53 basis points. This is more movement in two weeks than we sometimes see in six months.

 

There are many crosscurrents here. Most pundits are using the inversion of the yield curve as a forecast of a slowdown. But as we have noted in other pieces, economic slowdowns are far from synchronous with inversions. Growth continued for a year and a half after the yield curve inverted in 2006.

Looking at recent economic data, it’s pretty hard to find the slowdown:

– Retail sales advanced 0.7% month-over-month in July, versus an expectation of 0.3%.

– The Empire Manufacturing Index (New York survey of business conditions) advanced 4.8% versus an expectation of 2.0%.

– Core CPI is 2.2 % over the trailing 12-month level – right where it was at the end of December when the 10-year bond yield stood at 2.685% and the 30-year bond yield was 3.01%.

– The S&P 500 and the Dow Jones are still up double digits this year – even after this week’s turmoil.

– Second-quarter non-farm productivity is at 2.3% vs. a 1.4% expectation.

This does not look like an economy that is rolling over. Nor is it.

This is a bond market that has been buffeted by a number of factors that are not US-related.

Europe is mired in negative interest rates. The wisdom of having negative interest is strongly debated. One thing that is pretty clear to us is that negative rates have not helped the European banking system, and negative rates here do not help US banks, either – witness how poorly financials have done since the Federal Reserve changed its tune towards the end of last year.

The slowdown in China has pushed the yuan lower, and China’s growth rate has dropped. This has contributed to the rush into Treasuries. But we think there may be more playing out here, and it is symbolized by the protests in Hong Kong in recent weeks. Coming on top of the slowdown in Mainland China, the protests may herald the beginning of new freedom movements that the Chinese government will struggle to contend with.

How to manage bond assets
We continue to manage Cumberland total-return bond assets in a barbell method, accenting both shorter-term securities for liquidity and longer-term bonds to lock in yields, with what have been non-Treasury securities in the taxable world and longer tax-free bonds in munis. Indeed, with the fast rush down in Treasury yields, longer-dated munis, though at historical lows, offer value when you can get 3% higher grade in a world where long Treasuries are at 2%. We will take our chances with 160% yield ratios, knowing that defensiveness is built into the cheapness. The front end of the muni curve is VERY expensive relative to Treasuries, so even with a barbell and very low nominal yields, it’s been prudent to have exposure to the longer end of the market.The barbell strategy works less well when the Fed is at the end of a hiking cycle. We don’t believe the Fed is done yet: This is a pause in the Fed’s addressing the US economy. For all the change in talk from the Fed’s being on autopilot to now being data-dependent, the Fed has raised the fed funds target by 25 basis points in December and lowered it by 25 basis points last meeting; so from a fed funds target standpoint we are where we were last fall.

 

Equity markets are decently higher, and our economy continues to improve, yet the bond market has seen yields come down dramatically, in a manner that doesn’t square with US data but is more sympathetic towards the slower growth in Europe and China.

The trade war and concerns about slow growth notwithstanding, the US economy continues to do well. Our thoughts are that this race to the bottom in yields will slowly give way to a recognition that the US economy is on firm ground; the force of higher wages will push inflation higher; and the Fed will resume – albeit slowly – addressing the US economy. This is why Chairman Powell gave the markets a rate cut of only 25 bps last meeting though the markets were clamoring for 50.

Bond market yields here are high versus those in Europe, and that will keep a lid on things for a while. But the rush down has been overdone, in our opinion. My colleague David Kotok often likes to quote Herbert Stein, former chairman of the Council of Economic Advisers under Presidents Nixon and Ford. Stein’s commonsense “law” was that “If something cannot go on forever, it will stop.” We feel that’s true with long bond yields. The ride down in yields has helped portfolios. But backups can hurt, which is why we continue to get more defensive at the margin. The barbell is still in place.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio


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Cumberland Advisors Market Commentary – Report from Leen’s Lodge (Camp Kotok)

The 50-person gathering at Leen’s Lodge encompassed diverse political views, financial and economic specialties, and asset class focused from cannabis to currency trading, real estate to debt of all types, stock markets and ETFs, derivatives and futures, and more. Over $1 trillion in managed assets were represented as we gathered for each informal meal. No lectern, no PowerPoint. The China Panel and the MMT panel are public and in the social media domain and the press and public are free to use the video footage and quote the speakers. Other discussions were conducted under the Chatham House Rule.


There are some takeaways:

1. Regardless of the attendees’ political views, Peter Navarro’s advice to Trump is seen as a disaster. In a poll, 1 supported Navarro, 3 weren’t sure, and 36 disapproved. When asked more generally about Trump’s trade war policy, the group was divided, with about 3 opposed to Trump for each supporter.

2. The damage incurred by Navarro’s advice and Trump’s policy was cataloged in detail, and it is ugly. It is spreading and appearing in more and more evidence and anecdotes.

3. Border and immigration policies were discussed in detail and with data. The group’s outlook is bleak. Nearly all fault a dysfunctional Congress for its repeated failures. Here the group leaps over partisanship. Democrats and Republicans are guilty.

4. Global debt expansion and central bank credibility is a major concern. I refer readers to the MMT panel for a clear, multidimensional discussion of MMT and the Fed’s dilemma: Camp Kotok MMT panel. My personal takeaway is that the Fed needs to step up its game with regard to its communications strategy. Most agreed that putting a name with each dot in the dot plot would be an easy improvement to make. If the Fed had a clear policy statement against negative interest rates, that assurance would help to reduce risk premia. The gathering views negative rates as a spreading financial malignancy. The varied forecasts about proliferating negative rates and their global effects are sobering.  Kotok note: adjusted for most recent inflation reports, the US treasury yield curve is already negative when computing real yields.

5. The China panel packed an extraordinary amount of valuable information into a half hour and is well worth the time you’ll spend to view it: https://youtu.be/Sff0AGPrIJQ


 

This 2019 Camp Kotok talk session features panelists Michael Drury (Chief Economist for McVean Trading & Investments, LLC.), Jonathan D. T. Ward (Founder of Atlas Organization), & Leland Miller (CEO China Beige Book), all offering their take on U.S.-China relations. The panel and audience Q&A are guided by moderator, Lisa McIntire Shaw.

Beyond the direct China-US trade war, attendees discussed contagion risk, Hong Kong, Argentina, capital flight, and alternative choices for storing value in a world of discredited fiat money, among other issues. Most attendees expressed gratitude for an assembly that allowed for free and open exchanges under the Chatham House Rule.

Here are three questions for readers to consider:

1. How would you restructure your investment portfolio if you really believed that the global high-grade sovereign debt nominal yield would average 1% or lower for many years?  That implies real yields would be negative worldwide for a prolonged period.

2. How would you restructure your investment portfolio if you believed that high-grade federal, state, and local debt yield would also average 1% or lower for many years? This question implies that the entire yield curve (term structure) is under 1%.  What are implications for munis, mortgages, swaps, forwards, etc.

3. The third question involves geopolitical risk and personal safety. At Camp Kotok we had private conversation on this subject. The results are alarming as many of us have altered global travel plans. I’m one of those who has done so. So here’s the question. Think about the world that you see. Then make a list of every place you have visited during your lifetime. This takes a few days for older and well-traveled folks as memories are rekindled. Then look at the list and ask which of these destinations you would visit today and which not. Add this consideration: Which would you visit only with ample security and protection?

Lastly, Dave Nadig drafted an exquisite description of Camp Kotok and has given us permission to share it. Enjoy: https://www.etf.com/sections/blog/camp-kotok-wall-street-woods

We also have permission to share Brent Donnelly’s thoughts on Camp Kotok, 2019: Brent-Donnelly’s-Notes-from-Camp-Kotok-2019.pdf

David R. Kotok
Chairman of the Board & Chief Investment Officer
Email | Bio


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Cumberland Advisors Market Commentary –  Trump Tax Reform: Looking Backward and Forward

Two members of the research department of the Banque de France have published an interesting note important to US investors. We applaud the work of Cristina Jude and Francesco Pappada. The title is “Does the Trump corporate tax reform impact the composition of the US current account?” Here is a direct link to their paper: https://blocnotesdeleco.banque-france.fr/en/blog-entry/does-trump-corporate-tax-reform-impact-composition-us-current-account . We thank the authors and the Banque de France for permission to share this work with our readers.

Cumberland Advisors Market Commentary

The implications of their findings give us reason to pause and reflect on the impacts on US markets. Note how they describe the issue of “profit hoarding” and “profit shifting.” Also note the roles of “small jurisdictions,” which they list as Bermuda, Ireland, Luxembourg, the Netherlands, Singapore, and Switzerland. Their paper is well-documented, and links to their backup citations are in the paper.

I have been mulling over the implications of their comments on repatriation in particular. They present data to suggest that the transitory effects are nearly over. That development has implications for portfolio management. It also means that there are second-derivative implications as multinational corporations return to a baseline allocation approach to their foreign-sourced profits.

So the activity in stock buybacks and dividends and internal corporate decisions attributable to repatriation are shifting. Note that if repatriation had a positive effect on your portfolio, their research suggests that the positive force is spent or nearly so.

There is another secondary effect on the short end of the yield curve.

A multinational corporation that was engaged in “profit hoarding” parked cash in special types of accounts in order to qualify for deferral of tax to the US. Those accounts were often held in Treasury bills. The repatriation of those monies caused the Treasury bills to be sold and the cash to be moved into the US-based banking system. The entire process usually happened in one day. Note that the aggregate of Treasury bills and banking system aggregates was unchanged. It is the ownerships that changed.

Those changes occurred in the very short end of the yield curve. They happened at the same time that other forces impacted short-term interest rates, so there is no way to know how much of the volatility in the front of the yield curve was attributable to this transitory effect. What we do know is that the transitory effect is ending, if the researchers are correct in their observations.

Only time and retrospective research will reveal the impacts.

Our final takeaway is that the repatriation flows provided a tailwind to the US stock market. That tailwind happened coincidentally with other tax-code changes and with policy changes. It seems to be ending.

Without a tailwind, the US securities markets have to realign to its absence. We will see what that means this year.

At Cumberland we maintain a cash reserve in our US ETF portfolios. In our bond accounts we have been taking profits as the rally in the Treasury market has steamrolled and yields have dropped precipitously. We think it is time for more defensive posturing in bonds. Yields don’t fall forever, and stocks require earnings growth rates to rise.

Also note that the number of listed stocks in the US has been declining since the late 1990s (see Where Have All the Public Companies Gone? https://www.bloomberg.com/opinion/articles/2018-04-09/where-have-all-the-u-s-public-companies-gone). The average age of the remaining listed companies has nearly doubled. So we have a shrinking and older cohort of listed companies trading on the US exchanges (see How Did the U.S. Stock Market Get So Old? https://www.bloomberg.com/news/articles/2019-03-05/how-did-the-u-s-stock-market-get-so-old).

Fewer stocks, which are older and therefore more mature companies, combined with a post-repatriation paradigm – that is what faces the stock market in 2019–2020.
David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Cumberland Advisors invites you to our “Financial Markets and the Economy – Financial Literacy Day III” event, to be held April 11, 2019, from 8:30 AM to 4 PM at the Selby Auditorium of the University of South Florida Sarasota-Manatee.

Our focus is “Financial Markets and the Economy”, featuring:

Panels-
•    The Stock Market
•    Health Hunger and Philanthropy
•    How the World Looks to Me – A Global Economic Outlook

Special Presentations-
•    A Conversation with Susan Harper, Canada’s Consul Gen in Fla, on Trade/World Affairs
•    Keynote by Gretchen Morgenson, Senior Special Writer in the Investigations Unit at The Wall Street Journal and Former Business and Financial Editor for the New York Times.


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1Q2019 Review: Taxable Fixed Income

Short to intermediate Treasury yields declined throughout the first quarter as of March 19th, as the 30-year Treasury was flat at roughly 3.00%. The Treasury yield curve remains slightly inverted out to 5-years. This has benefited the Agency multi-step securities that we hold in portfolios, as we have witnessed an increase in calls as coupon steps are not justified by the inversion of the yield curve.

Cumberland Advisors Market Commentary

By the time this overview is received, the Fed will have made a decision to hold rates steady or hike the fed funds target rate. We expect the Fed Funds rate to remain unchanged at 2.25-2.50. In fact, the odds are higher that the next move will be a rate cut as opposed to a hike. The current rate-cut probability by the end 2019 is 25.1% versus a 0.5% chance of a hike, showing that market participants have major doubts on future rate hikes. We should receive additional clarity as to the direction of interest rates at upcoming Fed meetings.

With the uncertainty centered on the interest-rate environment, our portfolios have benefited from the inclusion of callable Build America Bonds, as they have provided a higher level of yield per unit of duration than shorter non-callable securities. Our taxable portfolios have also benefited from the inclusion of long tax-free municipals, as we have seen outperformance in that space. We will continue to manage portfolios defensively until more clarity on interest rates is revealed, and we will take advantage of opportunities as they become available.

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
Email | Bio


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The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s (source: Wikipedia), posited that when a team from the “old” NFL (the current NFC plus the Colts, Browns, and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the Super Bowl.

 

If a team from the AFC won the Super Bowl, the Dow would decline. Amazingly, this theory has worked out almost 80% of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017). The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

But we decided to have a little fun; and since it’s World Series time, we wanted to see whether there was any tie-in to how the BOND MARKET did in the calendar year following a World Series win by either the American League or National League. The easiest data to use was the 10-year US Treasury bond and its return in a calendar year. We measured TOTAL return (coupon and price) and then took away headline inflation (CPI). (By the way, we have this data in our bond models, so it was easy to deploy for a “fun” topic.) We went back to 1966 to have a similar time period to the Super Bowl.

Our results are below:

How the BOND MARKET did in the calendar year following a World Series win by either the American League or National League

What do the results tell us?Frankly, not as much as we hoped.

Some notes: We used the full calendar year AFTER the World Series. And we ignored 1995, which followed a year when there was not a World Series due to the players’ strike. In the bond market, 1995 was a big year because the market rebounded after the carnage of 1994.

In the 51 years that we measured, the American League won the World Series 27 times and the National League triumphed 23 times. The bond years following an American League winner had a positive return 15 years and a negative return 12 years. The AVERAGE bond market return following an American League winner was 2.39%. The average UP year for an American League winner was 9.12%, and the average DOWN year following an American League winner was -6.03%.

The National League numbers look a bit more promising. In the 23 years that the senior circuit won the World Series, the AVERAGE return was 3.06%, 67 basis points higher than the average American League return (remember, these are total returns, inflation-adjusted). The average POSITIVE return for the National League was 9.18%, fairly comparable to the American League’s 9.12%. But the average DOWN year for the National League was -4.88%, considerable less than the American League’s -6.03%.

At some point we may go back another fifty years to add to the study, since we have a much longer record for the World Series than we do for the Super Bowl (which started after the 1966 season).

But the results would suggest that the bond market on average does better after a National League win in the Series, with a slightly better upside number and a considerably better downside number. What does 2018 hold? Well the American League Houston Astros won the World Series last year over the Los Angeles Dodgers. But wait – the Astros were a National League team until 2013! So with this mixed history, the 10-year Treasury to date has a total return of approximately -3% through the end of the third quarter, with inflation of approximately 1.4% through the first nine months. That’s a total return through nine months (after inflation) of roughly -4.4%. If we have a flat quarter, that should suggest that a down year this year would be more like a National League return (and Houston was an National League team for all but six years of its 56-year existence). Of course the returns will change between now and the end of the year. The volatility in the equity markets, slowing housing markets in a number areas of the country, and possible worries about SALT provisions in the tax bill may start to push more assets into a bond market that has been oversold in general – particularly given that trailing headline inflation has dropped from 2.9% to 2.3% in the past three months.

As for next year, we know we fare somewhat better with the National League, but GO RED SOX!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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