Published on November 18, 2022
We believe the market is currently undergoing a substantial paradigm shift that could impact bond investors for years to come. The end result: We may be entering a golden age of income, reminiscent of a period in the distant past when investors focused on fundamentals and clipped coupons rather than prioritizing short-term price appreciation.
Since the early 1980s, the traditional long-term fixed income allocation, focused on yield and current income, became all but extinct. In its place, we witnessed the emergence of a new mindset that prioritized interim price movements, assisted by both the indexing and productization of every asset class.1 Capturing short-term price appreciation became part of every portfolio's return objective, whether the time horizon for that portfolio was one month or thirty years.
Just as market participants have been conditioned to redirect attention to short-term market direction from long-term fundamentals, so have economists and analysts. Much economic data is being analyzed and discussed at great lengths in financial research and media, with all manner of predictions being made for what the near-term consequences may be. But hidden in this data is a long-term story that may be hinting less at the timing of a new market cycle, which would play out over the coming months and years, and more at a paradigm shift, which would impact years and possibly decades to come.
Missing the Forest for the Trees: Are We Entering a New Market Paradigm?
Figure 1 shows the S&P 500 index since 1927. It is a chart that most investors have seen at some point, along with the overlaid chart of 10-year Treasury yields since 1976, showing the long period of declining rates that had spanned the careers of most market participants.
Figure 1: S&P 500 Index since 1928, 10-year Treasury since 1976. (Source: Bloomberg Finance LP)
Also since 1976, the average rolling performance of the S&P 500 in 1 year, 3 year, 5 year and 10 year periods has far exceeded the same measures prior to 1976. That means that, on average, regardless of entry point, an investment held for these lengths of time was more likely to be higher after 1976. Moreover, the standard deviation of the rolling returns was lower after 1976, so while there was a meaningful chance that the actual return deviated from this average, that chance was lower after 1976 than before (See Figure 2).
Figure 2: Average S&P 500 rolling returns have been higher with lower variation since 1976 regardless of the time period. (Source: Bloomberg Finance LP)
The reason we highlight this is that higher relative return expectations paired with higher relative stability of those returns became viewed as a permanent expectation as the numbers of investors who remembered markets prior to 1976 dwindled. But in reality, this new (and admittedly long) market paradigm was the result of several factors that began to appear in the mid-1970s that defined the last half century of investor behavior and expectations. And the data suggests it may be reversing.
Consider the following table:
Though many of these events are qualitatively meaningful, we want to start by highlighting the quantitative impact of the first one. The NYSE required brokerage firms to report margin debt balances from 1959 to 2017. Though we don't know why they suspended this reporting requirement, the data we do have give us an interesting lens into the impact of margin rule changes over time.
Using 1960 as a baseline level, we normalized the reported margin balances after adjusting for market moves (using the S&P 500 as a proxy for the overall NYSE margin account performance). We find it notable that after the Fed established the maximum initial margin level at 50% for stocks in 1974, margin debt roughly doubled. Prior to that point, the initial margin level ranged from 50% to 100% but was much less predictable. The certainty provided by the Fed since 1974 gave market participants the confidence to usher in a new era of leverage, fueled further by the decline in the cost of borrowing represented by lower interest rates. As we progressed through the 1990s, the combination of continually declining interest rates and the growth of financial engineering enabled enterprising custodians to introduce portfolio margining techniques.2 This golden age of hedge funds took the leverage levels in the marketplace even higher.3
Figure 3: NYSE Margin Debt Balances normalized relative to 1960 and adjusted for market performance of the S&P 500. (Source: Bloomberg Finance LP)
Alongside this quantitative boost to demand in the financial markets, it is worth also discussing the introduction of the 401k retirement plan in 1980. The psychological impact of the shift from defined benefit to defined contribution should not be underestimated. While we know the reasons this shift took place, the higher perceived uncertainty that one's retirement will be funded puts a 401k investor in the position of feeling the need to achieve higher expected returns and take more risk to make sure she will be secure in retirement.4
What resulted from all of these factors occurring in the span of roughly a decade coincident with the coming-of-age of the baby boomer generation is the start of a nearly fifty-year market paradigm that shaped the investing philosophies of almost every one of today's market participants. The question we are building up to in this commentary, which we will address next, is simple: Is this the end?
Appreciating Income When Prices Stop Appreciating
The bottom line: We believe the market is so focused on short-term economic considerations that it is missing the long-term paradigm shift which is currently underway. The tailwinds of an extended decline in interest rates and the associated increase in market leverage, as well as changes in market psychology regarding retirement uncertainty, contributed to an increasing focus on short-term relative performance, with investing mistakes more easily overlooked amidst a long-term bull market. In particular, fixed income portfolios were being viewed more and more as price appreciation strategies, with lower interest rates boosting returns despite low absolute yields. As a result, the growing focus on short-term relative performance and a newfound stability in expected market performance shifted investor expectations for their portfolios from current income, yield, and value to total returns by default. Put another way, an expectation of price appreciation became the rule rather than the exception.
The last half century was indeed a golden age for fixed income investors who did not mind that their “income” returns were dominated by price gains. In addition, as interest rates declined to the point where the cost of borrowing could be expected to be consistently below total returns, leverage became more valuable. Instead of just leveraging equity portfolios, investors could now leverage income portfolios and achieve equity-like returns. This crossover point took place sometime in the 1990s, and we believe the proliferation of hedge funds and derivatives businesses around that time is no coincidence.
While we don't think financial engineering or leverage is going away, higher interest rates generally make leverage less attractive or potentially non-economic for investors; persistently higher rates even more so. With recent data suggesting to us that consumer demand is poised to be higher for longer, we believe that the Fed will need to accept a higher run rate level of inflation. If they do not, we worry that they will overshoot on raising rates to lower inflation that they cannot tame, which would be catastrophic for the markets. Unfortunately, however, if they do recognize the need for a higher inflation rate for some time (but are just not saying it now for fear of how the market would react), the result may not be a prolonged rally in risk markets that might be expected from the typical turn of the economic cycle observed in the last fifty years. Rather, we believe the impending paradigm shift we are describing will turn those tailwinds into headwinds and cause an overhang on risk markets for a while. This will be most impactful on equity markets, with fixed income markets settling in for a prolonged period of high interest rates and yields.
In either case, it is our view that interest rates and yields will likely stay elevated not just on the order of months and years but on the order of years and decades. Investors may find that a long golden age of investing is coming to an end. This era fueled the indexing and democratization of the markets over the last forty years, but it also led to an overreliance on capital gains to fund retirements, spending, and savings. We are not saying that the markets will not experience the occasional bubble or see short-term periods of higher (and lower) performance. However, such moves are unlikely to be grounded in fundamentals and may only make sense for those tactical traders with the fortitude to trade a market that doesn't mask mistakes by trending upward. For long-term asset allocations, betting on price appreciation is likely to be met with frequent periods of disappointment. In the meantime, with inflation potentially remaining higher for longer, the tendency to treat cash as king may also be misguided.
So, where does the prudent investor turn in such a prolonged period of high inflation, high interest rates, little price appreciation, and increased volatility? We encourage market participants to focus once again, or maybe for the first time, on current income, yield, and value. Duration-managed credit markets provide an interesting opportunity to thread this needle, generating sufficient income to both overcome a period of higher inflation and provide a more predictable level of performance in a market that is likely to be volatile and stagnant for some time.
The silver lining is that a market overhang due to this version of an extended higher rate environment is a valuation-driven impact, not a fundamentally-driven impact. The economy should remain healthy enough for most companies to manage through this period, though multiples may compress. This is a much better outcome for Main Street and Wall Street than if we were to witness further earnings compression. Security selection in our view will be key to identifying those companies and investments which are best positioned to capitalize on an environment where "buying the market" may not be the seemingly guaranteed success it has been for the last fifty years.
Every End Is a Beginning
It is our view that the decades-long tailwinds of declining rates and structural upward pressure on the markets may have finally run their course. This is not meant to be a prediction of what will be but rather a warning of what could be. What we do see is a marketplace of investors focused on calling the end to the current economic cycle, preparing for a recession, and expecting a rapid recovery after some months or, in a bad case, years. If that is the case, most portfolios, including ours, will likely benefit. But we believe the last few years have distracted the market from a much bigger trend which may be taking us into a new paradigm. If so, we may be entering a new golden age of income, more reminiscent of a period in the distant past when investors clipped coupons and dividends and invested in companies rather than in asset classes and indices. For those seeking to preserve capital, a risk-focused approach to credit may provide a much-needed way to achieve consistency in an otherwise historically uncertain environment.
1 The proliferation of exchange-traded index funds has had the alarming effect of conditioning investors to trade every asset class as if it was an equity. This, combined with a false perception that all asset classes are fungible and should be judged primarily by short-term relative performance, in our opinion, has magnified the conditions hurting markets in 2022.
2 Portfolio margin is, simply speaking, lending against an overall portfolio level of risk rather than any individual holding. For example, while a single stock might justify a 50% margin rate, a long/short position might justify less margin, since any losses in the long should be offset by the short if they are correlated. That “if” is not a small one, as many portfolio margin models are sophisticated mathematical efforts, with key assumptions related to correlation among securities and asset classes in establishing the actual value of the portfolio which is at risk, the key determinant of the amount of margin the custodian would require.
3 Unfortunately, we do not have data after 2017 to see if margin has declined as the market started to anticipate an end to the Fed’s loose monetary policy after the taper tantrum in 2013.
4 For anyone with a background in derivatives, this inverse correlation between uncertainty and value will be familiar. Derivative models show that the higher the uncertainty of the terminal price of an asset, the lower the forward expected value of that asset. There is an important lesson from the 2008 financial crisis due to this modeling effect which is beyond the scope of this letter, but please feel free to ask us if interested.
5 The extreme version of this would see the Fed inadvertently drive the economy into such a deep recessionary hole that they would have no choice but to return to the free money policies that defined the last decade, further engraining the legend of the “Fed put” in the psyches of a whole new generation of investors. We wrote about this in our piece from August entitled The Fed Has a Third Mandate, and the Market Has a New Imaginary Friend.
Chief Investment Officer – Sustainable Credit
Venk Reddy is the Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management. Established in 1983, Osterweis Capital Management is an independent asset manager with $6.3 billion under management as of September 30, 2022. The firm provides investment management services to institutions and individuals through mutual funds and separate accounts, offering both equity and fixed income investment strategies.
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The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on
an overnight basis.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Coupon is the interest rate stated on a bond. The coupon is typically paid semiannually.
Standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.
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