For more insights, visit
us at csimfunds.com.
Insights
from
Brett
Wander
Chief Investment
Officer, Fixed Income
Perspective on global economic and fixed income developments
Embracing the improbable
September 2016
Unexpected and improbable events occur in all aspects of our lives, particularly
when it comes to investing. The current financial climate provides numerous
examples of this reality. From negative interest rates in several parts of the
developed world, to the U.K.’s unprecedented decision to leave the European
Union (E.U.) in June, to U.S. interest rates remaining historically low for far longer
than we once imagined, it’s a whole new world out there. In spite of all these
improbabilities, we believe that one particular point remains clear: U.S. bonds
are just as important as ever.
Improbable doesn’t mean impossible
As improbable as it may be, the U.S. economy isn’t anywhere near where
many pundits had predicted in the aftermath of the financial crisis. More than
seven years into the official recovery, economic growth remains unremarkable,
consumer prices are well contained, and short-term interest rates are really
close to where they were at the end of 2008. Meanwhile, yields on government
bonds have generally bucked conventional wisdom and fallen, instead of rising.
What’s behind this unusual series of events?
Lackluster economic growth in G7 countries has certainly played a predominant
role, prompting certain central banks to adopt negative interest rate policies in
a desperate attempt to stimulate growth. The notion that a country would
actively push short-term interest rates into negative territory may have seemed
improbable only a handful of years ago. Surely, such an effort would be expected
to cause savers to pull their funds from local banks, stuff their mattresses full
of cash, and the financial markets would face a meltdown. Yet this hasn’t been
the case.
Key takeaways:
•Improbable doesn’t mean
impossible, as illustrated by Brexit,
negative interest rates overseas,
and the Fed’s failure to hike
interest rates so far in 2016.
•Although economies in Japan,
Europe, and many other overseas
countries are rocky, we believe
U.S. economic fundamentals seem
reasonably sound.
•Given the complex market
backdrop, the Fed may not commit
to raising interest rates until it’s
convinced that such a move poses
minimal risks.
•Maintaining a well-diversified
portfolio that includes fixed
income can potentially help your
portfolio when improbable events
occur, and in our view, represents
a crucial step toward long-term
financial success.
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If you’re questioning the likelihood of someone accepting
negative interest rates on a deposit, consider the situation
in Switzerland. Swiss banks have started charging
consumers to hold deposits instead of paying them interest,
yet consumers aren’t pulling out all of their cash. So
although the thought of depositing $10,000 only to receive,
with certainty, $9,950 one year later may have once seemed
improbable, there’s no escaping this present-day reality.
Perhaps these savers view 10 to 20 basis points of negative
yield as a small price to pay for safeguarding their deposits.
Switzerland isn’t the only central bank employing negative
interest rate policies. The Bank of Japan recently joined
the below-zero bandwagon, with Sweden’s central bank
and the European Central Bank (ECB) having previously
adopted such an approach. Their rationale is simple: they’re
forecasting that super-low rates will motivate consumers to
spend more, and help companies to borrow more, hire more,
and expand. This, they hope, will translate into faster growth.
The Brexit improbability
Europe, where lackluster growth has been an ongoing
story since the financial crisis, is facing its own improbability.
“Brexit,” the nickname given to Britain’s vote to exit the
E.U., sent shockwaves throughout the markets in late June.
It’s interesting that some forecasts just before the U.K.
referendum estimated the outcome as essentially too close
to call. Yet investors seemed shocked at the reality that the
U.K. is now charting a course out of the E.U. Meanwhile,
the Bank of England is desperately trying to avoid the
country’s economic collapse, having cut short-term interest
rates to the lowest levels in centuries.
The generally higher
yields of U.S. Treasuries
make them attractive
compared with bonds
from other G7 countries,
driving up international
demand.
A different ballgame for the Fed
Unlike other G7 central banks, the Fed is trying to raise
rates, a hope that they’ve been expressing off and on
since late 2015. At a high level, the U.S. jobs market is
cooperating, with the unemployment rate hovering below
5.0%, signs of wage pressures emerging, and the overall
jobs market now seeming generally healthier.
However, one of the Fed’s central mandates—and
historically, one of the main reasons for raising interest rates
in the first place—is to keep inflation in check, and inflation
just doesn’t seem to be much of a problem right now in
the U.S. Factor in the tame inflation with merely modest
economic growth, and this gives the Fed more flexibility
regarding interest rate policies.
Nevertheless, a healthier economy in the U.S. compared
with other G7 countries and the Fed’s desire to resume
raising rates means that yields on U.S. Treasuries are higher
than yields on government bonds from other developed
nations. The chart below illustrates this relationship,
showing the comparatively attractive yields of 10-year
Treasuries versus the yields of like-maturity government
bonds from other countries.
G7 Government Bonds
-1.8%
1.58%
-1.6%
-1.4%
10-Year Yields
An appealing yield
Furthermore, 10-year Treasury yields have fallen about
70 basis points (a basis point equals 0.01%) or so this year
through the end of August—including an approximately
15 basis point decline since Brexit—since the Federal
Reserve (Fed) raised rates at the end of last year. So much
for the misconception that U.S. bond yields couldn’t possibly
go any lower!
-1.2%
1.02%
-1.0%
-0.8%
1.14%
0.64%
-0.6%
-0.4%
0.18%
-0.2%
-0.0%
Source: Bloomberg; 10-year maturity, generic government bond yields as of August 31, 2016, in local currencies.
2
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-0.07%
Ge
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-0.07%
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-0.2%
These higher yields enhance the international appeal of
U.S. Treasuries. To buy these securities, investors overseas
need to trade in their local currencies for dollars. This
additional demand can lead to U.S. dollar appreciation,
which makes U.S. goods and services more expensive
overseas, reducing foreign demand and potentially acting
like a brake on U.S. growth.
From this perspective, it’s not surprising that the Fed is
moving so slowly toward raising rates, and probably looking
for the perfect moment before doing so. One of the things
we think the Fed would like the least—and which would hurt
its credibility the most—would be to raise rates only to have
to lower them all over again a few months down the road
if the U.S. economy stumbled. We think that this makes it
even more possible for short-term rates to stay lower
for longer.
Although economies in Japan,
Europe, and other developed overseas
countries are still somewhat rocky, U.S.
fundamentals seem reasonably sound.
Key takeaways
With this improbable backdrop in mind, what do we see
in store for the fixed income market over the near-term?
Although economies in Japan, Europe, and other developed
overseas countries are still somewhat rocky, U.S. economic
fundamentals seem reasonably sound. Yet with the Fed
highly sensitized to even small data changes, it’s possible
that disappointing numbers just prior to a policy meeting
could derail any plans the Fed might have to raise rates.
In addition, even though the Fed doesn’t explicitly say much
In our view, this all means that the Fed
has much to consider, and that it may
not fully commit to raising rates until it’s
convinced that such a move poses
minimal risks.
about stocks, a spike in volatility like the one we witnessed
in late June after Brexit might keep the Fed on hold for
longer. In our view, this all means that the Fed has much to
consider, and that it may not fully commit to raising rates
until it’s convinced that such a move poses minimal risks.
So what are the key takeaways for investors? Namely, that
improbable doesn’t mean impossible, so maintaining a
well-diversified portfolio always makes good sense. We
believe that a well-diversified portfolio includes an allocation
to fixed income, and U.S. Treasuries in particular. These
securities can help to balance the equity portion of your
portfolio when it’s most in need of support, and if you
wait until an improbable market event occurs to diversify
properly, you may miss out on some of the potential
benefits. Moreover, in the current environment, bond yields
could potentially stay low for much longer than previously
anticipated, and we think this is particularly true for U.S.
Treasuries. In short, fixed income is just as important
now as ever!
Brett Wander, CFA
Chief Investment Officer, Fixed Income
Charles Schwab Investment Management
3
About the author
Brett Wander is Chief Investment Officer (Fixed Income) of Charles
Schwab Investment Management, Inc. (CSIM), a subsidiary of
The Charles Schwab Corporation. Wander joined CSIM in 2011 and
is responsible for all aspects of the firm’s fixed income and money
market portfolios, leading a team of more than a dozen investment
professionals. Over his more than 20 years of investment management
experience, Wander has been intimately involved in the design,
development, and oversight of a wide range of active, indexed, and
alternative fixed income strategies. His expertise spans a wide range
of global and domestic markets and sectors. He is a frequent industry
speaker, presenting at conferences and in various media forums. He
has taught MBA-level investment courses at the University of Southern
California. Wander earned an MBA from the University of Chicago and
a BS in system science engineering from the University of California,
Los Angeles. He is a Chartered Financial Analyst ® charterholder.
Past performance is no guarantee of future results.
The opinions expressed are not intended to serve as investment advice, a recommendation, offer, or solicitation to buy
or sell any securities, or recommendation regarding specific investment strategies. Information and data provided have
been obtained from sources deemed reliable, but are not guaranteed. Charles Schwab Investment Management makes
no representation about the accuracy of the information contained herein, or its appropriateness for any given situation.
Some of the statements in this document may be forward looking and contain certain risks and uncertainties.
The views expressed are those of Brett Wander and are subject to change without notice based on economic, market,
and other conditions.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income
investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments,
early redemption, corporate events, tax ramifications, and other factors.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
©2016 Charles Schwab Investment Management, Inc. All rights reserved. IAN (0916-LN26) MKT93563-00 (09/16)
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For more insights, visit us at csimfunds.com.