Perhaps the most widely held belief amongst market prognosticators over the past year was that virtually all public market assets were generally expensive and that volatility was expected to increase. So to many it was no surprise when volatility in the Treasury market caused movement in equities not seen in years. Professional investors, especially those who focus on historical relationships of asset values, have been anxiously awaiting interest rate “normalization” after a decade of Central Bank intervention. That time appears to be now, and it comes when federal budgetary needs will be sizable and underlying financial market liquidity is misunderstood. Recent volatility should remind investors why they invest with active money managers who focus on diversification and quality assets, and why managers have been modestly conservative over the past few years. After a long stretch of not being rewarded for this approach, we have entered a point in the cycle when prudence, portfolio flexibility and proper diversification will once again prove valuable.
Many have long been concerned with the magnitude of debt transferred from the banking sector to the federal government since the 2008 financial crisis. The U.S. Treasury market is an important foundation for pricing across all capital markets. At a time when Federal budgetary needs are reaching historic levels and require robust new treasury issuance (i.e. supply), this foundation may be vulnerable. Should interest rates move higher toward more normalized levels, there may be a leveraged effect on all other asset classes (corporate, high yield and emerging market debt, real estate, equities, etc.) due to their historical link, directly or indirectly, to treasury rates. As a result, there should be heightened sensitivity to the adjustment of treasury rates as they rise, and the speed at which they rise.
It is unknown how normalization will unfold. Will interest rates and inflationary pressure rise as a result of an expanding economy, or will they occur over concerns about the U.S. budget and an increase in the country’s debt burden? The former is preferred and the Federal Reserve has had a favorable environment to maintain interest rates “lower for longer” as inflationary pressures have been virtually non-existent over the past five years. This was aided by declining commodity prices, an absence of wage pressure (typically attributed to increased productivity due to technology), a modestly growing U.S. economy, and a deleveraging global banking system. These factors have reversed course, are no longer deflationary, and are beginning to put upward pressure on interest rates and force the Federal Reserve to adjust base rates higher.
These actions would be acceptable under most market conditions, but the U.S. Administration has simultaneously implemented tax reform to boost economic growth and re-energize the job market. Viewed in isolation this reform could be considered constructive, but it also increases the budget gap by an estimated $1.5 trillion, adding to the already large Treasury supply scheduled for this year. As interest rates rise the cost of servicing this additional debt will likely become a budgetary issue on its own, and buyers will likely demand higher yields given the expected level of future issuance. The importance of foreign buyers (China, Japan, etc.) may complicate the situation due to the pursuit of protectionist trade policies by the Trump administration.
An additional issue has emerged in the securities market over the past few weeks as regulations and technology cause structural changes in the true liquidity of capital markets. Over the past five years, the flow of assets into passive instruments has been extremely powerful in our opinion. This constant flow of capital has masked the true underlying liquidity of markets, something that is far lower than most believe it to be. In a world with fewer market makers incoming capital flows have been the primary liquidity provider. However, declining corporate profit margins caused by higher cost of capital may cause capital flows into risk assets to become less one-sided and liquidity to decline significantly. We are entering a new phase of the market cycle.
Another major change in the markets is that the vast majority of equity volume throughout the typical trading day is now performed by algorithmic trading systems which follow and participate with the trend of the market. When stocks sell off and volume increases, trading algorithms can exacerbate the sell off by selling more, thereby creating a vicious cycle. This can occur very quickly as we’ve witnessed the last few weeks. This issue is not isolated to the equity market, as the lack of liquidity providers and the pervasiveness of algorithmic trading across all assets can result in in higher volatility.
These awakening giants of inflation and illiquidity do not necessarily result in negative outcomes but will undoubtedly force market participants to re-evaluate their approach and positioning.
Michael Tiedemann is CEO/CIO of Tiedemann Wealth Management.