U.S. Treasury rates have been on the rise this year, gradually reversing the record lows seen in the third quarter of 2012. In May, investors saw what a quick rate reversal can do to the markets as 10-year Treasury yields rose 50 basis points, from 1.6% to 2.1%. The sudden spike has affected virtually all major asset classes, from safe-haven fixed income securities to equities. Not surprisingly, all major bond indices suffered losses, even the high yield index, which is typically more correlated to equity markets. U.S. stocks largely held up, but supposedly defensive income-generating sectors such as Real Estate Investment Trusts (REITs), Utilities and Telecommunications Services saw significant losses (see display).
HIGHER RATES HURT BONDS, DEFENSIVE EQUITIES
|Bonds||May '13 Returns (%)|
|Barclays US Aggregate||-1.78|
|Barclays US Aggregate High Yield Index||-0.58|
|Equities||May '13 Returns (%)|
|MSCI Emerging Markets||-2.57|
|FTSE NAREIT Composote Total Rreturn||-6.62|
|Select S&P Equity Sectors||May '13 Returns (%)|
Recent bond market volatility is primarily linked to expectations that the Federal Reserve will soon begin "tapering" the asset purchases that are part of its quantitative easing (QE) program. Since launching its most recent round of easing measures, the Fed has been buying $85 billion in longer-term Treasury and mortgage securities every month in an effort to stimulate the U.S. economy. With signs of economic gains, recent rhetoric from Chairman Ben Bernanke and other Fed members suggests a willingness to temper asset purchases sooner than was expected. Also, some Fed members are voicing concerns that reduced yields on risky assets might result in excessive risk-taking in the marketplace. As a result, consensus is building that "tapering" could occur as early as September.
Is that realistic?
From our perspective, the fall timeframe seems a bit premature, given that inflation remains benign at around 1%—far below the Fed’s 2% target—and may even decline. Also, while payrolls have improved, they have not reached a level that would quickly reduce the unemployment rate to the Fed’s desired level of 6.5%. To act too early could cause the Fed to underachieve on its mandates of maintaining steady price levels and maximizing employment.
As a result of the recent volatility, we believe the Fed will likely move to calm nerves by communicating its intentions more clearly should further yields spikes disrupt the markets. Investors remain cognizant of the 1994 rate hikes that triggered short-term losses in almost every asset class and caused a slowdown in the economy. With this in mind, the Fed may reiterate support for QE at some point to curb expectations of sudden rate increases.
Notwithstanding further efforts to slow asset purchases, we expect the Fed Funds rate to stay close to zero until early 2015. As such, the U.S. is likely to remain in an environment of easy monetary policy in the near and intermediate terms.
For the past few years, Neuberger Berman’s Asset Allocation Committee has had a bearish view of safe haven assets, particularly U.S. Treasuries, as they have looked rich compared to historical valuations. With real yields still in negative territory, we believe it’s likely that interest rates will continue drifting higher, but only gradually over the longer term. The Federal Reserve’s long-term projection for interest rates lies closer to 4% and, while we believe the Fed should guide rates closer to its projected number over time as the economy heals, recent volatility indicates that periodic rate spikes may become more common.
Consistent with our views that the Fed will not "taper" in the near term and with the U.S. economy strengthening over time, we see various areas that long-term investors may wish to consider:
- Despite their recent run-up, equities are trading at 15 times 2013 earnings—closer to fair value but by no means expensive in a historical context, particularly as the U.S. economy gathers steam.
- Cyclicals appear cheaper than some defensive, income-oriented sectors, and could even prove more resilient on lower expectations.
- Credit spreads, particularly for high yield bonds (at around 435 basis points) may compress further over time as default rates stay low.
- Certain non-traditional assets such as lower volatility hedged strategies may also be appropriate diversifiers as cross-asset class correlations decline.
© Neuberger Berman