Perspective on global economic and fixed income developments

Unprecedented markets, inexplicable risks

March 2016

Key takeaways:

  • Don't overreact to China! Focus on the long-term instead, and stick to your investment plan.
  • If you bail out of bonds because you think the Fed will raise rates several times this year, you might be disappointed. Instead, stay invested.
  • Even if the Fed does raise rates further in 2016, longer-term bond yields could actually fall, so think twice about selling them.
  • Don't trade in your U.S. Treasuries for other Group of Seven (G7) government bonds just because you think yields are higher overseas. They're not!

The first week of 2016 was the worst first week of a year for U.S. equity markets on record,1 and conditions have remained quite rocky ever since. As troubling as this start to the year may be, the circumstances surrounding the market's volatility are even more of a concern. So far in 2016, it's been all about China, the Federal Reserve (the Fed), and global economic growth. So let's discuss what we can expect for the rest of this year.

China: what's really going on?

When asked what's causing such enormous angst and turmoil in the financial markets, "it's China" has been the common response. So let's dig a little deeper to gain perspective on why China has been having such a jarring effect.

Financial markets are typically driven by a combination of fundamental and technical factors related to economic growth, inflation, corporate profitability, supply, demand, and the like. But what's happening in China goes well beyond these traditional drivers.

Consider the following:

A new perspective for U.S. investors–Most U.S. investors are used to focusing on the U.S. economy. The notion that another country's economic woes can hugely impact U.S. financial markets isn't something that U.S.-centric investors are used to facing. China has changed this mindset.

China's unknowable GDP–There's a great deal of focus on the growth rate of China's economy. Is it growing 7%, 5%, or 2% annually? The range of possibilities seems bewildering, and that means risk. It's not like in the U.S., where economists fret when growth changes by a fraction of a percentage point. Significant risk in China means a great degree of uncertainty, which the financial markets can't stand.

Lack of transparency–Markets can't stand a lack of transparency, either. Investors seem to appreciate the relative reliability of U.S. economic data. Even when an outlying statistic pops up, we have experience calibrating margins of error to put the number into context. No such confidence exists with Chinese economic data, so there's very little transparency.

A foreign system–China's system is quite "foreign" to U.S. investors. Unlike the U.S., China enacts massive governmental support for its stock market, limits short selling, and implements a variety of circuit breakers. Underlying this is a massive pool of inexperienced retail investors. What does it all mean? It means risk.

Was January an early warning for the rest of 2016? Certainly there will be periods of volatility, but regarding China, the longer-term question is this: how much do Chinese economic conditions matter to the U.S. economy? Answer: there's undoubtedly some impact, but not nearly enough to justify the market gyrations we’ve seen so far this year.

"Ignore the noise... If the latest events aren't causing a lasting shift in fundamental conditions, then your asset allocations probably don’t need to shift, either."

So what's the key takeaway? Ignore the noise. We think you'll be far better served if you focus on your long-term investment plans—and stick to them—instead of reallocating your holdings whenever short-term market events erupt. If the latest events aren't causing a lasting shift in fundamental conditions, then your asset allocations probably don’t need to shift, either.

What's up with the Fed?

Though the Fed raised short-term interest rates in December of last year, they've only just begun the "normalization" process. The timing and speed of this process—and the additional rate hikes required—will depend on a number of economic and market factors, particularly inflation.

Remember last September? The Fed seemed on the fence about raising rates, and no doubt global equity markets— China in particular—were on their minds in a big way. The Fed seems desperate to keep raising rates. Not by a lot, but by enough to show that they're confident in the U.S. economy and committed to lifting rates back up to healthier levels.

The Fed began 2016 with a forecast that four rate hikes— at approximately 0.25% per quarter—would be a sensible expectation. This would have pushed the federal funds rate target up to around 1.25% to 1.50% by the end of this year, a level that would arguably seem more normal. However, as underscored by recent Fed comments, this is probably not going to happen.

What will get in the Fed's way of raising rates? Inflation is a big challenge; there's just very little of it in sight. What the Fed won't say is "China." In fact, at none of the Fed's recent announcements or minutes has the word "China" been mentioned. Why? We believe it's because they don't want investors to think that they're focused on external factors that aren't directly affecting the U.S. economy.

What's the point? Rates could remain low at least as long as problems in China and across the globe continue to rock U.S. financial markets. In this type of environment, we think that the Fed will keep rates accommodative much longer than if conditions were less volatile. This could help fixed income performance in 2016.

Chart: Treasury Yields

"If you believe that bond yields are set to rise just because the Fed has started raising rates, think again."

Aren't bond yields heading higher?

If you believe that bond yields are set to rise just because the Fed has started raising rates, think again. U.S. Treasury yields are generally lower than where they were at the time of the Fed's mid-December 2015 rate hike. For example, at the end of February, 10-year Treasury yields were around 1.75%, more than 50 basis points (0.50%) below where they were as of mid-December. Why? It all comes down to a lack of inflation, which is a big driver for longer-term bonds. Even if the Fed hikes rates further in 2016, intermediate- and long-term bond yields may remain low if inflation expectations stay tame.

The critical takeaway is this: don’t bail out of bonds just because you think that interest rates are heading higher. With inflation contained and global markets in disarray, the Fed could keep rates steady for quite a while. Moreover, even if the Fed were to raise rates, that doesn't necessarily mean that longer-term bond yields will rise. Fed rate hikes can sometimes push yields on longer-term bonds lower if the market views these actions as proactively helping to keep longer-term prices—a.k.a. inflation—in check.

Have you seen the negative rates OUTSIDE the U.S.?

Not everything has been about China. Central bank policies are also playing a part in financial market developments. Unlike the Fed, many central banks around the world are lowering rates to stimulate their economies. Several countries have even tried to raise rates only to lower them shortly thereafter, as their economies have failed to ignite. As a result, bond yields are even lower in other Group of Seven (G7) nations, as shown in the chart above. Compared with U.S. Treasuries, 10-year sovereign government bond yields across Europe, Japan, and other nations are miniscule.

So what's the lesson to be learned? As long as low (and in some cases negative) yields persist outside of the U.S., any potential increase in U.S. bond yields should be limited. This should support the performance of U.S. fixed income securities in 2016, particularly the performance of Treasuries.

Looking ahead

Each year CSIM's Fixed Income team makes a list of all the major risks and uncertainties that have the potential to befall the economy and markets. Inevitably, something unprecedented and unforeseen seems to occur. The insight is this: expect the unexpected, try to understand investment risk in its broadest context, and don't overreact. Remember that U.S. economic fundamentals remain reasonably sound in spite of the developments in China and Europe, so don't overreact to short-term market disruptions. Instead, stick to your long-term investment plan and remember that as long as global market volatility persists, the Fed will be that much less likely to raise short-term interest rates again anytime soon. Even if the Fed does raise rates, don't assume that longer-term bond yields will rise in response. Also, don't forget that yields are relative. Sovereign bonds across the G7 countries yield less than U.S. Treasuries right now, a point worth remembering if you’re thinking of trying to look for higher-yielding opportunities overseas.

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Brett Wander, CFA
Chief Investment Officer, Fixed Income
Charles Schwab Investment Management
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