July 17, 2018

Several of the themes discussed in our previous quarterly review remain relevant. While 2017 produced a very strong, and calm, domestic stock market, 2018 began with a departure from that trend. As of our writing, 2018 is still providing a bumpier ride for stock investors. Yet, looking past the markets, underlying economic indicators are strong. Jobs data is particularly notable, as unemployment remains at record lows.

Trade also continues to dominate headlines and introduce uncertainty. Last quarter, we commented that there would be winners and losers in a protectionist trade regime. In general, consumers will experience price inflation, while some domestically focused industries and companies may benefit from reduced global competition. Our research efforts include considering the effects of announced and proposed tariffs, incorporating trade hostilities as a risk factor in our quality screens—a tool we use to evaluate companies held in Clifford Swan portfolios. 

Turning to fixed income, there is much to report. The Federal Reserve (Fed) persists in steadily increasing key, short-term interest rates. Consensus opinion is that gradual rate increases will continue. Concurrently, the Fed also continues to unwind its balance sheet, decreasing the sizeable bond purchases it made during and after the financial crisis. This also exerts upward pressure on interest rates. While interest rates remain at low or moderate levels, we see the Fed’s actions as positive developments for our clients. They should translate into higher coupons and reinvestment rates in portfolios going forward.   

Beyond the Fed’s actions, other market influences also play a role in defining interest rate levels. There is a battle emerging in the bond market, as two different theses about the overall economy seem to be at odds. On the one hand, businesses and the economy are doing well. Unemployment is low. The labor market is tight, and there is potential for wage inflation. In this scenario, we may expect to see higher interest rates than we are currently experiencing. On the other hand, the alternative thesis is one of “secular stagnation,” a description of negligible economic growth. We are in a nine-year recovery since the financial crisis, but growth is still somewhat muted, and inflation has not really appeared yet. Interest rates are increasing but perhaps not by as much as one would have thought. 

In navigating these divergent theses, we seek safety, quality, and lower duration (a measure of price sensitivity to interest rate changes) in bond portfolios. At Clifford Swan, we do not believe in taking excess risk in fixed income. We employ equities for growth (and higher returns) and bonds for stability and income. In evaluating corporate bonds, we analyze the balance sheets of issuing companies, making sure we feel confident that investors should not lose committed capital. With municipal bonds, we research individual states and localities, looking again at balance sheets and revenue sources, to assess risk. 

More broadly, we also pay careful attention to the yield spread between different bonds. In other words, we evaluate the amount of additional compensation (yield) we think investors should earn according to the risk their bond holdings present. Treasury obligations are the ultimate safe haven, backed by the full faith and credit of the United States. Accordingly, corporate bonds, which carry company-specific risk, should reward investors with more return. Our opinion in the current environment is that bond investors are not, in general, being duly compensated for taking the additional risk associated with owning corporate or municipal bonds, when compared to Treasury securities. As a result, we are purchasing more Treasuries in client portfolios, until the opportunity set changes.

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