Bob’s Journal for 1/3/2019
While Treasury bonds outperformed stocks in 2018, what happened within the bond markets was more important to investors.
Stocks outperform bonds over the long term, but bonds have better years from time to time. Treasury bonds have outperformed the major stock indexes for only a few calendar years since the end of the financial crisis.
In 2018, the S&P 500 declined 5.39% and achieved its first negative year since 2008. Bonds didn’t have a banner year, but they did better than stocks.
Long-term treasury bonds lost only 1.98% in 2018. Investment-grade bonds, as represented by the Barclay U.S. Aggregate Bond index, declined only 0.16% in 2018.
That performance shows that once the Fed stops supporting the stock markets and begins tightening money, investors increasingly can benefit from balancing and diversifying their holdings. Since the Fed began its extraordinary monetary policy in 2009, returns to diversified investors weren’t as high as returns to risk-takers who loaded up on stocks, especially the riskiest stocks.
Bonds outperforming stocks in 2018, however, wasn’t the biggest news for investors. What happened within the bond market, especially in the last quarter of the year, was more critical.
Treasury bonds and investment-grade bonds held up well because investors who were concerned about safety bought them. Riskier bonds didn’t do as well as treasuries.
The Bank of America Merrill Lynch High Yield Index declined about 2.70% for the year and 4.80% for the last three months of the year. November was the only month in a long time when no new issues of high-yield bonds came to the market. Several investment banks planned to bring new issues to market but delayed or canceled them because the market was too weak.
Leveraged loans, sometimes known as bank loans, also did poorly late in the year.
DoubleLine Floating Rate (DBFRX) is one of the top-performing funds in the category and emphasizes the safety of principal instead of reaching for higher, riskier yields. It had a 0.01% return in 2018. But over the last three months of the year it lost 3.11%, and it lost 2.32% in December.
Another sign of weakness in the credit markets is that the spread between interest rates on high-yield bonds and treasury bonds widened as high-yield rates rose much higher than treasury rates did during the year.
This is only the fourth year since 1987 when both the high-yield and investment-grade bond indexes had negative returns, according to Bespoke Investment Group. It is the worst year for high-yield bonds since 2008 and their third-worst year since high-yield data was first compiled in 1987.
This action in the bond market shows several things. The Fed’s tighter monetary policy is having effects. There’s less money in the economy, so companies have to pay higher yields to borrow.
The economy also is slowing as a result of the Fed’s policy, and that makes investors more concerned about credit risk. Only a few months ago, investors would snap up bonds issued by firms with low credit ratings that offered few or no protections in case of default. Now, investors are more selective, and some firms can’t obtain credit at all.
The decline in stock prices is closely correlated with weakness in the credit markets. That’s no surprise. When investors are worried about cash flow and companies being able to pay their debts, they’re also worried about earnings.
The good news is that the recent weakness in the corporate credit market is nowhere near levels of past crises. We have a long way to go before we reach levels similar to those in 1994, 1998 and 2007.
But the credit picture is another reason to be cautious about stocks. Lower stock prices are closely tied to concerns about corporate credit. Until something happens that makes investors more optimistic about the high-yield bond and leveraged loan markets, stocks are likely to be weak.
The Data
Higher interest rates and a slower economy continue to affect the housing market. The Pending Home Sales Index from the National Association of Realtors declined 0.7% for November, following a 2.6% decline for October. The index is down 7.7% over 12 months.
The Chicago PMI declined only a little, from 66.4 to 65.4. This is a very high level. For more than a year, this survey of businesses has been stronger than the others. It includes both manufacturers and non-manufacturers.
The Dallas Fed Manufacturing Survey indicates manufacturing nationwide could be stalled. Previously, the latest Richmond and Philadelphia Fed surveys reported dramatic declines. The Dallas Fed’s General Activity Index came in at a negative 5.1, compared to a positive 17.6 last month. This is the first negative reading of this index since September 2016 and the largest month-to-month change in the 14½ years of the data.
The PMI Manufacturing Index also found the manufacturing sector slowed dramatically. Coming in at 53.8, the index was down from 55.3 last month and is at its lowest level in 15 months. Even so, the 53.8 reading is considered an indicator of strong growth.
The ISM Manufacturing Index also declined sharply from 59.3 to 54.1. That reading is its lowest level since November 2016. Again, the 54.1 level indicates solid growth but that growth is progressing at a lower rate than it had in previous months.
But the employment market appears to be strong, according to the data leading up to tomorrow’s Employment Situation reports. The ADP Employment Report indicated the private sector added 271,000 new jobs in December. That’s well above expectations and is the highest level since February 2017. The monthly average for this report in 2018 was 203,000 new jobs created.
New unemployment claims increased 10,000 to 231,000. That’s above expectations, but the claims data usually are volatile around the holidays. We’ll have to wait a few weeks to see if this is a new trend.
The Markets
The S&P 500’s return was 1.62% for the week ended with Wednesday’s close. The Dow Jones Industrial Average gained 2.03%. The Russell 2000 added 2.07%. The All-Country World Index (minus U.S. stocks) rose 0.43%, while emerging market equities rose 0.62%.
Long-term treasuries gained 1.77% for the week. Investment-grade bonds rose 1.06%. Treasury Inflation-Protected Securities (TIPS) added 0.52%. High-yield bonds eked out a rise of 0.02%.
On the currency front, the dollar fell 0.16%.
Energy-based commodities lost 1.26% for the week. Broader-based commodities fell 1.89%. Gold rose 1.32%.
Bob’s News & Updates
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