Large-caps and growth stocks outperformed for the second month in a row in February leading to a slight year-to-date growth edge across all size groups: +2.7% vs LV, +1.8% vs MV and +1.7% vs SV. The S&P 500 is already up nearly 6% year-to-date after advancing 4% in February while the Russell 2000 advanced a more modest 1.9% during the month and is up 2.3% year-to-date.
Companies across most economic sectors did well in February though Materials and Telecom stocks were essentially flat. Energy stocks declined 2% continuing the down trend from January.
VIX remains near its lowest levels as the stock market continues to rally and the Term Spread continues to hold steady around 2% signaling a very low chance of a recession in the near term.
We continue to be concerned that much of the asset allocation advice in the industry is relying too heavily on past-30 year returns in financial plan projections leading to overly conservative outcomes that stand too high a chance of failing to meet financial goals. To understand why we are concerned, it is constructive to take a closer look at bonds.
Short-term interest rates and inflation expectations are the two components that make up the long-term interest rate. The Federal Reserve raised short-term rates in December, while signaling to expect multiple rate hikes this year, and inflation reached 2.5% in January, its highest level since early 2012 and well above last year’s 1.26% rate. These developments are likely to have adverse impacts on bond holdings with implications for projected bond returns.
Bond prices are inversely correlated with long-term interest rates so when interest rates increase, bond prices decrease. The magnitude of the decrease in price depends on a bond’s duration, a measure of the sensitivity of bond prices to interest rates. It is easier to understand duration as the time it takes to recover the price paid on the bond. We can use duration to calculate the effect that interest rate hikes will have on a bond’s price. The Vanguard Intermediate Term Bond ETF (BIV) declined in value following each of the past two interest rate hikes on December 3, 2015 and November 9, 2016 by 0.87% and 1.18% respectively. Using its current duration of 6.4 years, we can calculate the expected decline from these rate hikes by multiplying the change in the 10-year yield by duration to arrive at 0.96% and 1.22%, similar numbers to the actual declines seen in 2015 and 2016.
Based on the Federal Reserve’s comments and inflation expectations, rising interest rates are likely to restrain bond returns. Longer-term bonds with longer durations will be more affected than short-term bonds but short-term bonds still are not paying very much income. The asset allocation process is complex and must balance your individual ability and tolerance to take risk but expectations for bonds should be discounted based on today’s environment. While the long-term case for increasing equity allocations is strong there are other asset classes, too, that can provide diversification benefits. A good question to ask yourself is one we ask on one of the last slides in our SSR Workshop presentation: Is your asset allocation appropriate?