Exploring Market Volatility: What Recent Events Could Mean For Stocks, Bonds, Oil & More

Question: Does a Bear Market in equities or risk assets have material significance, or is it just another number or headline?

 

Scott Kimball: At this point, I think a bear market is a given, because we’re in one.  The question is, “what kind of bear market?” If it’s “typical” we should be in the latter innings.  If it’s “atypical” then all bets are off. Given the areas of the economy which are coming offline, it’s more than just travel—sports tournaments are getting cancelled. I don’t personally think we are out the woods yet in risk.  I also think this period of, “what the heck” low bond yields isn’t going away anytime soon either.

With Guest
Scott Kimball, CFA 
Portfolio Manager, 
BMO Global Asset Management

Scott Kimball is a Portfolio Manager with BMO Global Asset Management. He is responsible for the firm’s investment policy and strategy and manages client portfolios. He joined BMO in 2007 and served as a research analyst prior to joining the portfolio management team in 2011. He is also a member of the management committee.

Previously, Scott held positions at Merrill Lynch and other boutique investment firms. He began his career in the investment industry in 2003.

Scott holds an M.B.A. from the University of Miami and a B.A. in international business from Stetson University.

 

In addition, he is a CFA® charterholder.

NEW: Episode Transcript

Rick Unser (00:00):

Well Scott, welcome back to the podcast. It's been an interesting year so far, 2020 in the markets and I know you've been keeping a close eye on things so I can't wait to hear what you have to say.

 

Scott Kimball (00:12):

Right. Thank you Rick. I appreciate you or having me back on. So always a great opportunity to, to connect with you and, and your audience and great opportunity for us to to share our perspectives, what we're doing here at BMO fixed income.

 

Rick Unser (00:24):

Awesome. And on that note, I know you're a fixed income guy, but I think you've got some great perspectives and as we talked about last time, I think there's a lot that you bring to the table that I was really excited to kind of get your perspectives on. So I guess let's just jump in with, you know, 2020 we finished great in 2019 so far, 2020 has been anything but boring. Tell me a little bit about what you're seeing. I mean, obviously people from a headline standpoint are really concerned about the Corona virus and in its impact, but is all of this market reaction driven by the coronavirus or is this really, now all of a sudden we're starting to see some cracks in the facade and people are much more concerned about other things that have been kind of lingering beneath the surface maybe for a little while.

 

Scott Kimball (01:15):

Certainly I think you, I think you characterize that perfectly. It's been an interesting start at 2020 after what was really a, an uninteresting 2019 and that it seemed that in 2019 everything worked. Fixed income performed very well, equity performed very well. Real estate performed very well. So across the board in 2019 no matter what you owned, whether it was, you know, treasury duration, investment grade, corporate bonds, high yield securities, everything in fixed income eked out a positive return in some instances to a very robust return in others. So that leads us to 2020 and from a fixed income perspective and probably a broader risk market perspective as a whole, things were priced for a very constructive, very positive environment. There were episodes of 2019 where we thought there were some headwinds for risk, but we sort of pushed past them and just grew towards 2020 with a lot of positive momentum across asset classes.

 

Scott Kimball (02:20):

So that sets the stage for how we got to 2020 but to, to really tackle the second part of the question of what's Corona virus impact versus others, we have to sort of set the other stage, which is that throughout this cycle really going back to 2008 or so through where we are today, this expansion we've seen in the U S economy and its expansion across all markets has been a positive thing for investors and that we've seen a lot of positive return and a lot of growth in assets, but it's common with periods of volatility. And we think of 2015 with the oil in China crisis, if you will. And what that created in terms of volatility. And then we had the trade war kickoff and that caused a lot of volatility and each of these instances we saw that with bigger growth comes bigger downdrafts and more volatility.

 

Scott Kimball (03:10):

So here we are in 2020 a market that was priced for very positive outcomes. A market that was really showing valuation metrics across asset classes that showed steady economic growth with really no threat of a downfall or a downdraft encountered something unknown. And coronavirus was certainly unexpected and unknown and that has become a major talking point from all areas for which markets take input. Market participants and investment managers are talking about it investors, whether they're retail investors or institutional investors are talking about it. The government is talking about it and because of that uncertainty, the market is trying to discount what the likely impact is. And right now what we've seen, if you look at where treasury yields are, where risk has repriced in the corporate bond market, in the high yield market, and even in the equity market, it's pricing in that this can't be compared to other viral outbreaks.

 

Scott Kimball (04:09):

And other health epidemics. This can't be quite as well contained and that we're going to see major changes and disruptions in key economic drivers. So for example, supply chains. A lot of that has been offshored over the years, so develop market economies. A lot of what we produce originates overseas in markets that are affected by this virus. You see container volumes into major ports from Los Angeles through Jacksonville, Florida, and where I am here in Miami, container volumes are down. The read through through the economy is that although the U S was on very strong footing heading into this crisis, there's some concerns about this might cause the good economy to sour and the recession that many people have been focused on is going to come to fruition because of this. I would say that it's probably about 80% of what the market has been focused on is grown a virus.

 

Scott Kimball (05:00):

There are other factors. Certainly the U S political cycle is coming to the forefront. There's been some unexpected candidates that had done well at certain points and other more, I guess we'd call them incumbent or better known candidates that were lagging and the market had to discount that as well. Because when we think about from a policy standpoint, there were some very different views that were being expressed in the market, has to figure out what the likely impacts would be on things like banking for example, or the consumer. So that also was an undercurrent to the Corona virus. I will say now, Sunday evening money of us got a surprise by way of the oil market saw the single largest drop in oil since the Gulf war, about a 25% decline in oil prices because Saudi Arabia and Russia, two major oil producing nations started a price war. What that means is they're both going to keep pushing up production and they're going to lower their cost and in some cases probably even lose money.

 

Scott Kimball (05:59):

And the idea is they want to have the cheapest oil being consumed by the most people and they want to damage their competition, which is sort of classic price war economics, which is that I am going to take as much pain as I possibly can bear because I believe you'll take more. That probably increased its share of the other factors share of what's going on in the market. So it became 80% coronavirus is now probably, you know, 50% and the rest is probably what's going on with oil and the commodities market we saw yesterday in particular just the sheer amount of selling in the bond market of oil debt, corporate bonds sold by oil producing companies, record falls in bond prices and surges in yield. So now we have two significant currents in the marketplace that are weighing on things. We have the coronavirus and we have a growing concern over the oil market and what that might mean for, you know, default rates of high yield issuers, et cetera. I'd say those are both now probably pretty balanced in terms of market perception. So it's a 50 50 tug of war between both of those

 

Rick Unser (07:06):

Let me  digest this in in kind of increments or or markets for a second and obviously you'll a lot of the, let's call it headlines have been focused on what's going on in the equity side of the market and maybe just help me put this in perspective, but obviously the market has been volatile, but I, I think I saw something saying that this was one of the quickest market corrections, one of the, one of the most, you know, compact market corrections, whatever the right term is that we've seen in history. Is that right? And in what does that maybe say about the overall I guess health or orderliness of the equity side of the market at this point?

Scott Kimball (07:54):

Certainly, and when we look at equity markets, I'll say risk markets, equity is equity. Like for example, high yield, fixed income are our risk markets and they both exhibited one of the fastest corrections in market history. We believe here that that tells us two things. One was the obvious one we already knew, which is that we were at all time highs, inequities. We were at all time low in bond yields and what that means is those markets might have gotten, people will use the term overvalued, others will use the term frothy. Others will just say they were markets were too high. But from our perspective it tells us first and foremost regardless of what the underlying valuations were. We were an uncharted territory in terms of levels. So investors were owning markets at valuations or at levels that they've never owned them in the past.

 

Scott Kimball (08:48):

So when an uncertainty comes through to market Corona virus, the oil situation with Saudi Arabia and Russia, even the U S election cycle, having some rather unexpected results along the way, the market has to digest and apply what we call a discount mechanism. What that means is what's the impact going to be? Two things that we're invested in based on these factors and it was a lot of factors at once and there were a lot of heavy factors to digest on top of what was a really high or a frothy or a stretched market in terms of valuations. So the result is you have very large price declines and bond prices have a very strong surge and bond yields. As a result. Those two going opposite directions and equity markets. Similar story, you had large point drops in the market because 5% or 10% of a very high number ends up being a larger point dropped and we're at lower levels, so it's telling us overall that markets were owned at very high levels, very high multiples, very low yields, more so than ever in the past and we encountered what are probably some of the more difficult things for us to discount.

 

Scott Kimball (10:04):

It's very difficult to discount something related. A health concern such as a new virus. It's very difficult to discount what the impact is or what the staying power is of oil price war between Saudi Arabia and Russia. It's very difficult to discount a political cycle in any market environment and doing all of that at once on top of very high valuations produce the result that we've seen in the last week to 10 days or so.

 

Rick Unser (10:28):

Yeah, and on a prior podcast episode I had Robert not at research affiliates, you know also with PIMCO and he and I were chatting before all of this, so we were kind of chatting early January and he really echoed a lot of what you just said there, which is, Hey, you know, this market on the equity side just is basically priced to perfection is making all sorts of assumptions about sustained growth rates and everything else and Hey, I don't know how long this goes on. I don't know, it could go on for a long time, but he was very, I think precious. Not saying that he knew coronaviruses was coming, but just saying that, Hey, a little blip here could cause some pretty significant reactions just based on equity valuations, taking some trim to assumed growth rates that could send ripple effects through the, through the market. Obviously, I'm paraphrasing is, I'm not directly quoting Rob, but to the extent you want to hear some more about that, that that was a great episode, but I think Scott just obviously parallels a lot of what you're saying there on the equity side of this or the risk side of this. I guess you've mentioned oil, we've talked a little bit about Corona virus. Are there some other things that you're seeing on the equity or risk side of the markets that people will have some concerns about or is adding to uncertainty?

 

Scott Kimball (11:51):

Yeah, there, you know, I'll tell you a what's in the background of all of this has been this, this environment in Europe, you've had Brexit on the table. Now our position when Brexit was announced was this might take a decade. A lot of folks disagreed with that, but here we are about seven years in and it's looking like we were more correct and we were wrong on that front. Unfortunately for markets, so there's uncertainty about the construct of the EU at this point that's still lingering and that's reverberated into persistent negative rates overseas. And the challenge is we always in the fixed income marketplace, we always described to and believe that zero lower bound meaning interest rates can't go below zero was a rule a hard and fast rule. We've seen in Europe that between negative central bank rates and negative rates in sovereign debt, so for example the German Bund negative interest rates on short term investment grade corporate bonds and negative rates, even on some high yield securities in Europe, all areas of the fixed income market have broken zero lower bound.

 

Scott Kimball (12:59):

So what that means to us here in the States is if we look at treasury yields, we can't just assume that zero is where it stops and that the market as a whole has gotten away from looking at yield and fair value on treasuries, at least over what's going to be the short to intermediate term in our estimation. It's not looking at yield on treasuries as an indicator of value or longterm inflation expectations or making those decisions that we used to make in the fixed income market of do I want to buy a 10 year treasury? Do I want to buy a five year treasury and buy another one in five years? Do I want to buy a one year treasury, 10 times? All those things that allow us to assess the value of interest rates are sort of being thrown out the window and rates and us treasuries are being bought as an asset allocation vehicle and asset allocation tool because they correlate negatively with riskier assets and from an investor's perspective they're saying, well if I have to buy a 10 year treasury at a half percent I know that of equities go down another 10 or 15% the treasury will at least have pretty strong positive returns and if I get paid a half percent for owning it now versus having to pay negative half percent to own it, I don't really care because what I'm concerned about is the way the treasury functions against other asset classes in the wake of uncertainty.

 

Scott Kimball (14:21):

That dynamic and that change in the perception of what yield means on government rates in particular is a major undercurrent in our opinion to what's going on in risk markets because we've changed the way fixed income is being used and we're continuing to try to interpret what low bond yields mean for other asset classes and we recognize that the way the market is using them is different than in the past. So that's another element of uncertainty that that is probably running beneath the surface of coronavirus oil tantrums, political cycles and all those other factors we talked about

 

Rick Unser (15:02):

And I want to come back to that, but before we move on from the the kind of the equity or the risk side of the market, you've mentioned the political environment a few times. I guess, correct me if I'm wrong, but I think what I've heard a lot of people say is that at least kind of end of 2019 early 2020 valuations were really based on not a lot of change in either the executive side on the presidency or in Congress, and that that kind of will carry over status quo in, in the upcoming election cycle. So when you say some political concerns, are you suggesting that now the market's saying, Hmm, what happens if we don't have a Republican presidency and that flips to a Democrat? Is that the concern you're talking about or is there something else?

 

Scott Kimball (15:53):

So, you know, when we look at the history of markets and politics and political cycles, there's a few things regardless of who's in the white house, regardless of the composition of the executive branch, it's very difficult to unseat incumbent presidents when the economy is going well. So now we have some concern about the direction the economy's going because of the coronavirus and some other factors that we've talked about, the oil situation between Saudi Arabia and Russia. That calls into question where the U S economy is going to land on the balance of 2020 so the probability of change in the executive branch and this administration, unless you haven't been following markets recently, I think all of us are probably looking at this change in the markets and this volatility and thinking that there must be some impact or some political implication or at least the market's perspective. Even if there's not going to be a change in the administration, the probability of a change has increased because that's what history tells us about recessions and elections is that incumbents do very well when the economy is on firm footing.

 

Scott Kimball (17:08):

They are sort of a toss up when it's not. Now the U S economy was on very firm footing heading into this. There's a better than average chance that it comes through the other side and regains this momentum, but at the same time the market has to account for the fact that it might not and that level of uncertainty on the political side is certainly weighing on markets. On the other aspect of it, there are a lot of things you can do to track the market perception of who nominees will be. So on the democratic side, you know the Sanders campaign has fought long and fought hard now over two election cycles and has going through the Nevada primaries seem to have a neuro stranglehold on the nomination. Now that may have changed a bit on super Tuesday with some other dynamics, but nevertheless the market has to discount that policies from the Sanders campaign, even if he's not the nominee.

 

Scott Kimball (18:02):

The strength of his campaign is likely to influence policies of whoever the likely nominee is if it's not him. So the market is also digesting and discounting that not only could there be a change in the executive branch, but if there were a changing executive branch, there's uncertainty of what those policies would be. So when we say markets are discounting mechanism, that's what we're talking about. The markets are really one big probability function that looks for what the implied probability of future events are likely to be and then changes them based on new information. So we have new information in terms of the U S economy. We have new information about the composition of what at least the democratic policies that are going to be presented will be during the election process and all of those are factors. The market has to weigh into its equation about where it feels the future direction of not just the economy but markets as a whole are are headed.

 

Rick Unser (19:02):

That makes sense. Let me pivot you back to where I think you were starting to give some really good information on the fixed income side of the market and I've heard a lot about negative rates. We've talked about negative rates a couple of times on the podcast. Obviously I would agree with you. I actually had a conversation the other day with somebody who's like, what are you in? Rates are negative. I'm like, what Tate? Just look at Europe. There's, you pick your country and you can, you can pretty much find examples of negative rates, but I gotta be honest. I still struggle to explain in rational terms what negative rates are and what the implication on an investor, a borrower, an individual. How do you explain that or how would you put that into language that somebody who doesn't have a degree in economics or a PhD could understand or relate to?

 

Scott Kimball (19:59):

I appreciate the question. I will tell you I will, I will do my best because I tell you as a fixed income market professional, I and my colleagues, my industry, we are, we are struggling with this question amongst ourselves,

 

Rick Unser (20:11):

So it's not just me.

 

Scott Kimball (20:12):

No, absolutely not. Negative interest rates are sort of an oxymoron in the sense that an interest rate is how much you're charging someone to borrow money and now a negative rates is how much are they gonna pay for you to borrow their money. It's a very interesting way or a very difficult dynamic to unpack. You know the concept of, okay, if I need to borrow $1,000 it's going to cost me 5% too. If I'm going to loan you $1,000 I'm also going to pay you to take it. It's a very interesting dynamic and the implications long term we're struggling with. What I can tell you is the market is probably looking past it and saying, you know, if we think about negative rates from a treasury rate, from some of us treasury perspective, I should say, if we're looking at negative interest rates, let's just say we have another prolonged sell off and the U S treasury copies the German Bund and becomes a negative half percent yield.

 

Scott Kimball (21:09):

Let's just put that out there. What we know is if the interest rate is negative, it likely represents more of an insurance premium than an interest rate. Meaning that if I buy a treasury and I have to pay money to own it, what I'm really doing is paying negative half percent yield so I can own the asset class. That will do well if everything else I'm invested in melts down so it becomes almost more of an insurance perspective. I'm paying a premium to protect myself from downside risk. That's probably the best way I can convey why I believe negative interest rates are occurring. That's the best way I can probably convey it. Now, 10 years from now, you and I would probably be an under podcast and hopefully I was wrong and they just all went away. But if they're still there, then this perspective of what yield represents is that it's become on the government yield side more of an insurance premium than an actual yield.

 

Scott Kimball (22:05):

What that will mean for consumers unfortunately is I don't think I'm about to give the answer. A lot of consumers want to hear, which is that credit card rates and mortgage rates and small business loans and things like that are going to drop tremendously from where they are now and that you'll see credit card rates in the low single digits for you know, your average FICO score. Unfortunately, when negative rates indicate is a high degree of market risk with high market risk credit spreads, which is the extra premium we get for bearing credit risk. So if a treasury is just to say 1% and a corporate bond is 4% the credit premium is 3% it's the difference. Same thing for consumer loans. If I am a a financial institution and my cost of funding is 1% and I'm charging a consumer 8% my premium is seven my credit spread is seven in a negative rate environment, the level of risk in the system is so high, that's pretty likely that the credit premium remains very high if not goes higher, so falling credit card rates is probably going to be a nice idea, but I'm very unlikely to occur.

 

Scott Kimball (23:21):

Unfortunately for most consumers. In reality, auto rates are always generally pretty low because the dealers or the manufacturers do the lending and they're just trying to get you to buy their car so they're fronting the money and in many times they do it at below market consumer rates, so auto rates, which are already pretty low in many cases are are likely to remain low. They're certainly going to go below zero but 0% APR financing and things like that on auto loans, I just want to put that out there. It's not a true interest rate market. It's more of the manufacturer fronting the money on the sale and eating the interest rate costs through the price of the car. So that's kind of a distorted market. The one I'll spend a little more time on is mortgage rates. If there is a rate in the market that tracks yields that the consumer can benefit from the most, it tends to be mortgage rates.

 

Scott Kimball (24:18):

They're already very low call three to three and a half percent as it sits today for your 30 year good quality FICO score, 30 year fixed rate mortgage. If we backtrack and look at the financial crisis, that is an area where we saw in a stressed market, a negative market, a challenging credit market. We did see mortgage rates track broader market yields and head down. Now will they go to zero? Certainly not because there's a cost to servicing a mortgage. The mortgage servicer who collects the payments and sends it to the investors, they charge, you know, a half percent, three quarters of a percent. The banks origination costs are going to remain positive. So even if you see negative treasury rates, it's unlikely that mortgage rates follow it. We will say that we've done some modeling on this. We think the floor for how low mortgage rates can go for a consumer is probably somewhere in the twos, maybe, you know, two and a half, two and three quarter percent is probably about the floor because of the cost of the mortgage and the fact that investors are not going to buy mortgages with negative yields that just they would buy the treasury with negative yields.

 

Scott Kimball (25:27):

So it's unlikely that they would follow suit into the mortgage market. So there is gonna probably be some further decline in mortgage rates, but we do caution people, we're already very low. We don't know if it's got the power to go much deeper in terms of you know, mortgage financing costs. Now a 15 year mortgage rate might go as low as you know, one and a half or one and three quarters percent for 15 year versus 30 that market tends to also track interest rates down, but the main rates consumers are going to be facing every day. Credit card rates, things like that. Probably not going to follow interest rates much lower from where they are now.

 

Rick Unser (26:05):

One of the things you said earlier, and I think this relates to what you were just describing there, is that if we do see rates stay maybe at current rates or even go a little lower or dip to negative potentially that might not be as related to what people think about the prospects for growth or inflation or some other things that I think historically people have said the 10 year treasury for example, has been tied to is the 10 year treasury or maybe the spread between various treasury yields are an indication of what the market thinks inflation is or an indication of the market thinks growth rates are going forward. So did I hear you right and maybe that that is no longer a great mechanism or am I putting some things together that shouldn't be.

 

Scott Kimball (26:55):

I think you're correct. So as a fixed income professional, I want to believe that over time interest rates reflect the fundamentals of the economy. So when the treasury rate what we expect the treasury bond to be composed of, we think the yield on a treasury note is going to reflect a few things. One is inflation, so if we put money into it, we at least earn a rate of inflation. We expect to be paid for our time, meaning that if I borrow or I buy a treasury at a certain interest rate for 10 years, I expect that there's a small amount of compensation I received for the fact I didn't do other things with the money for 10 years. I lend it to the treasury and there's also liquidity, meaning that I do have to sell this in the future at an unknown price to get my money out.

 

Scott Kimball (27:43):

So we expect treasury rates to reflect those things. Inflation time, liquidity effectively at this current interest rate cycle. We're now, as we talk today, looking at treasuries that have called 10 year treasury at about a half percent. It's difficult to believe that the market's estimation based on all current information, including things like the Corona virus and the oil situation between Saudi Arabia and Russia. It's difficult for us to believe that over 10 years, a half percent will compensate us for all three of those things. That inflation will be some minuscule amount. You know that liquidity premiums don't matter. And that time premiums don't matter that that's the only way you can make sense of a half percent treasury, which is that you think the global economy is going to roll over into a recession and that growth rates will be negative and inflation rates will be zero to negative and that investors will pile into assets with no regard at anytime in the next 10 years for liquidity or their time.

 

Scott Kimball (28:46):

So it leads us to the conclusion that if the market really doesn't believe those things, but at the buying treasuries anyways, what's happened over the near and probably the intermediate term is investors are focused squarely on treasuries do well when other asset classes don't. So if I get paid a half percent to own them today, so be it. If I have to pay a half percent because the yields go negative to own it today, so be it. What I care about is if stocks sell off, if high yield default rates increase and because of that high yield bond prices fall, my treasury and my core bond portfolio has gone up and I've recognized a diversification benefit because of it. And due to that diversification benefit, I'm looking at the total return potential from bonds and saying I don't care what they're paying me today. Now the evidence we would offer is if you look at 2018 German Bunds started the year with a negative yield for the whole year, they returned in the upwards of 20% because the yields went more negative.

 

Scott Kimball (29:50):

So we look at this and say that is a market where people are buying German bonds at a negative yield from more of an insurance perspective and they are buying them because they know they do well when other things don't and they don't really care about the yield. We believe this is a phenomenon that exists that has entered the U S market today. We think it will exist hopefully over no more than the intermediate term. And over the longterm things will go back to some sort of normalcy, but it's the only way we can reconcile the yields. We've seen the market today with where we think the economy will be over the next five to 10 years. There's a disconnect between what we think growth will be and what we think the actual output will be versus what yields are indicating they will be.

 

Rick Unser (30:37):

And I think people have been pretty cognizant of obviously the drop and the volatility in the equity market. I feel like that's obviously gotten a lot of headlines. I think people kind of see and can feel that in their 401k plans or other investments they might have, but there's been a pretty precipitous drop in treasury yields or interest rates as well. W w what does that look like behind the scenes and what does that do to the fixed income markets and does that have kind of a similar disjointed or disorienting effect in the marketplace or is that not quite is magnified as maybe what we're seeing on the equity side?

 

Scott Kimball (31:19):

You know, I would say that the drops in all markets had been unprecedented and the shock and awe of the decline in equities is at least the same and maybe even a little more. In the fixed income world, we've seen negative rates overseas. You see a 10 year treasury drop to half percent. You see a 30 year treasury fall below one and it does it on volatility statistics that are unprecedented in the market. So I think this has been a increase in volatility across all financial assets. It's certainly has highlighted the power of diversification and why you own core fixed income in this environment because it does well when other things don't. It is a diversifier and in that world of efficient frontier investing in asset allocation models, if anything, it's shown that not only does the return profile of fixed income give you a hedge or a benefit against other assets, it also gives you a volatility hedge because this, the rising volatility in equities, and I'll say high yield debt as well has been offset and matched by the increasing volatility in treasury yields and core fixed income. That can be true in both directions, but in this case, the volatility of riskier assets has been offset by the upside volatility in bond prices. So that has been a pronounced effect across markets. And while it certainly can lead to some gnashing of teeth about where the rates actually landed, it also reasserts that as an asset class, despite the low yields fixed income is very relevant from an asset allocation perspective.

 

Rick Unser (33:07):

Oh good point on that. And I think, you know, we've talked about diversification a couple of times in prior episodes and I think, you know, as, as some would say, it's if you really have diversification, you're always frustrated with something because that means that not everything is performing well at the same point in time. And the other thing that I think is an interesting point is typically the market's not going to give you a warning sign that, oops, it's time to put your, get your diversification set up or it's time to put your you know, hedging positions in, so to speak. So it's I think what we've seen over the last several weeks is really case in point to that.

 

Scott Kimball (33:45):

Yeah. I think that if there's anything that I would want the listeners to take away from our discussion, it's they have to maintain that asset allocation perspective and throughout history. If you look at buying fixed income based on yields over the last 25 years in investment grade and high yield, if you look at the yield on fixed income at the start of the year and what the returns were the following 12 months, those two only approximate in the case of investment grade or high yield within one or 200 basis points respectfully, so one or 2% respectively. They only come within the total return a handful of times, so yield is not a great approximator of what your returns will be over the next 12 months. But diversification we talk about in this industry we use a lot of fancy terms correlation, how much things move with or against each other over time.

 

Scott Kimball (34:49):

That diversification benefit, that correlation benefit, that negative correlation benefit in the case of core fixed income versus equity, that is proven to be your better predictor of results over the next 12 month period. So as you look at your portfolios today and you look out in the future, if there's a key takeaway, it's that the reason you've made these decisions to be committed to an asset allocation, this market has proven perhaps as much and over the short term as any other market cycle in the past. It's proven why you made those decisions and the reasserts that diversification and being somewhat agnostic to, you know, today's valuations and sticking to your plan is what pays dividends over the long term. 

 

Rick Unser (35:37):

And that's a great point because I think if someone's just looking at this saying, Oh my gosh, I've got a 10 year treasury, it is under 1% or I've got 30 years that are at or under 1% whatever it is. It's like why do I really want to get involved in that? If, if from a yield standpoint, I'm looking at something that is incredibly minuscule. So I think that's a, that's a really good point that you just made there about that disconnect between yield and returns. Let me pivot you one more time. You've mentioned oil a couple times and I don't know, on the face of it, Hey, oil has gotten cheaper. That's good for the consumer. That means hypothetically lower gas prices, my consumable income goes farther on a, on a weekly, monthly, yearly basis, whatever the case is. How is it that lower oil prices have sent such a major shockwave through the marketplace when maybe on the surface one could say, well this potentially helps the consumer and isn't the consumer important to the overall strength of the economy?

 

Scott Kimball (36:45):

I think that's a a great question. And one that I know a lot of people have, and it's one that we internally here at our firm have had been discussing about the implications across a couple of different dynamics. I'll say first and foremost, you are correct that lower oil prices benefit those who are consuming it. So from the perspective of a U S consumer over time, lower gasoline prices, lower energy prices is a, is a tailwind to our spending. If we're saving $30 a month on gasoline prices, that goes in our disposable income. For other things, it's an extra dinner, it's an extra whatever you choose to consume that before you were, you were paying out of necessity into the energy market. So it functions a bit like a tax cut in a way. The thing is over time, through efficiencies and principally, but also through the introduction of alternative power sources, the amount that we spend on energy, the energy sensitivity of the U S consumer is lower than in the past.

 

Scott Kimball (37:52):

It's meaningful, but it's less than it's been in the past. So we don't get quite the tailwind that we did 10 15 or 20 years ago. And also oil prices have been a little depressed relative to their peak for about five years now. So it's not quite the tail wind that may be was in 2015 or so when prices went from over a hundred dollars a barrel, you know, into the forties or thirties that was a demand related issue because people were concerned about slowing growth in China, less consumption. The issue we have today is a supply related one and this is probably what has concerned the market a bit more. The market acknowledges that in the long run, this is fine for the U S consumer and lower energy expenditures are welcome, but over the near term the market has to grapple with. You have Saudi Arabia, OPEC and OPEC leader, you have Russia oil producing nation as well that are pumping up supply levels to make prices depressed in the hopes of hurting the other one, but also hurting third parties.

 

Scott Kimball (38:57):

So for example, us oil producers, this is bad for them too. So U S oil producers can't compete in a price war started overseas. What will eventually happen is they may go out of business, so that is a negative for unemployment. That's also a negative or a bad thing for the high yield market because a lot of energy players rely on funding their energy need, their energy investment in the high yield marketplace. If high yield default rates were to increase, that would cause the cost of financing to go up and becomes very self fulfilling. So over the very near term, the market's looking at a price war between Saudi Arabia and Russia first and foremost saying if there's two countries we don't want getting into it with each other. It's these two, both exceptionally powerful nations in their region and accepted and systemically important to the energy market.

 

Scott Kimball (39:53):

But beyond that, their price mechanisms falling to their costs. Meaning that if Saudi Arabia takes a barrel of oil and it costs them $15 in Russia, cost them 18 and they drive oil prices down into the high 20s or the teens U S oil can't compete at that level, which would lead to some of the things the market is pricing in such as increasing defaults and maybe some marginally higher national unemployment because of a lot of our drilling and a lot of our production coming offline here. So over the longterm, yes, a consumer tailwind, not as much as it's been in the past, but still a tailwind. But over the very near term, this is a market headwind.

 

Rick Unser (40:39):

I think that was an excellent explanation on the oil side of things. And I guess that gets me just thinking about what else are people concerned about? Obviously I think there's a lot of focus on the here and now with you know, coronavirus interest rates now oil, I guess if you get your crystal ball out and you look three months out, six months out, a year out. I know we've already talked about kind of the the political side of things, but I don't know. I get thinking about earnings. I get thinking about other maybe market indicators that that we're not thinking about or talking about in this particular podcast setting that maybe others are are have their eye on as secondary or other things that say, Hmm, this is the Canary in the coal mine that that says we might have another issue that we're not thinking about or talking about in the here and now.

 

Scott Kimball (41:33):

There's a lot

 

Rick Unser (41:34):

Of things, for example, of all the things that you mentioned there, there's a lot of things to interpret, a lot of different directions. Those things can go, but if we wrap them all together coronavirus you have the state department suggesting people not go on cruises, so that's not, obviously that's obviously a major headwind if not a major speed bump for the cruise industry, but the read through for earnings from leisure and travel, airlines, hospitality, gaming, even retail, it has to take a hit. Earnings expectations have to come down. If we expand that and look at energy falling, energy prices, energy earnings, you know also have to come down. So everything that you just highlighted, we can trace back to corporate earnings and it's a negative headwind. And furthermore, with a negative headwind for cap ex, which is what I think a lot of people were counting on as the next leg in the economy was some necessary cap expending to push growth a little bit further.

 

Rick Unser (42:34):

That is now getting diverted into other things or just held out of concern for the market or fear. So all those things together we can sort of distill into having negative implications for corporate earnings, which is unquestionably what the market is discounting. Yeah. And, and I think that from the earnings perspective, I would agree that is somebody trying to factor that in at this point. As we know, the market hates uncertainty. So I would imagine a lot of what we're seeing at this point are people that are saying, Hm, maybe we're off by 20% Oh, what if we're off by 30% or whatever the case is. My perception is that that's what's driving a lot of this volatility is just that speculation of how, how deep is the cut, how deep is the, the risk here and how does that affect our models are returned assumptions, et cetera. Is that my head down the right path?

 

Scott Kimball (43:32):

Yeah, absolutely. Everything we're talking about has a an effect on an input to all of those, those models and those equations and quite simply as we make those numbers lower, the market pricing mechanism corrects the other direction, lower equity prices, higher bond yields and risky bond. So high yield, even higher bond yields in some parts of investment grade and lower treasury yields. That's basically the play by play a of of what's causing this in the market.

 

Rick Unser (44:02):

So I think you've done a great job kind of helping us understand why the volatility is the way it is today. Some of the broader impacts here, I guess, let me pivot us to a lot of our listeners are involved in some way, shape or form in 401k plans, whether as an employer, as a retirement service partner, whatever the case may be. So the question on, I think a lot of people's minds at this point is, well, what am I communicating to the average investor? Or how am I helping the average investor get their arms around what things that they should or shouldn't be doing at this point in time? I'll let you kind of take that however you want to, but I would definitely love any thoughts you have on, Hey, if I'm a equity mutual fund holder or if I'm a bond mutual fund holder late, like what am I thinking at this point? What are my expectations going forward, et cetera.

 

Scott Kimball (44:57):

So there's a lot of different directions to cover about, you know, we've covered a lot of, a lot of them over the course of this conversation, but I appreciate this question because it, this sort of ties it all together because I think if we're, if there's anything we're guilty of in, in, in the financial markets, meeting market participants such as myself, we talk about a lot of things, but then we don't tie them all together with the, okay, but so what do I do? And this particular case, this market that we're talking about now, I think this is an important moment where us as financial professionals and portfolio managers, we need to be exceptionally clear about the, okay, but so what do I do? I think that the most important thing I would convey to investors is understanding the power of your asset allocation choices and that right now as you look at your 401k balances, if you're a plan sponsor and you're looking at your pension fund balances or you're an individual investors looking at your broad portfolio, whoever you are participating in the marketplace, your portfolio has unquestionably had a significant reaction one way or the other depending on if you were heavy fixed income or heavy equity to this market.

 

Scott Kimball (46:08):

And what this has proven to us and reasserted is there's reasons why we talk about asset allocation is the reasons why we talk about diversification. So I'll start off through the lens of fixed income. I have spent the bulk of my career in a declining fixed income marketplace. In fact, all of us in fixed income have been dealing with declining interest rates for the bulk of our careers. And at some point the conversation became only about rising rates. And because of that concern, people turn their heads away from fixed income and looked to make decisions based on things with only higher return potential. So they carried a lot of equity, maybe have carried some high yield because they wanted the income, they looked at other alternative 16 com strategies. Anything they could to try to diversify away from the risk of rising rates. Rising rates is a risk to fixed income investing.

 

Scott Kimball (47:08):

There's, there's no question about it. However, diversifying away from that one risk has led to over owning perhaps some other asset classes, perhaps a bit more than you were comfortable doing. So if there's anything we've learned from this most recent iteration with not just decline in risk prices and equity and high yield, but the surge in bond prices is that diversification and the way these asset classes interact with each other is the more powerful discussion to have. So instead of looking at a very narrow concern, rising rates and using that to drive your entire fixed income decision, look at the balance of your decision and recognize that yes, just as equity prices can go down so can have fixed income prices if rates go up. However, I want to make sure that if equity prices declined by some percent, I own the amount of fixed income that makes my total portfolios decline tolerable.

 

Scott Kimball (48:12):

I'm willing to accept the possibility of rising interest rates and what that could do for fixed income and recognizing that will probably be offset by some pretty good performance in other asset classes. But I'm going to make sure that my decision on my asset allocation reflects the risk return profile I believe I'm supposed to have and I'm not going to focus just squarely on one individual factor to drive my allocation decision. And if you look at the way fixed income has performed, it turns out that the fear of rising rates and bailing on on duration and fixed income because of that, that ended up being the one factor you were supposed to own really over the last 30 years, but principally in the last 10 in the U S fixed income market in particular. So the main thing as you look through where your portfolios are today never ever questioned the power of the asset allocation.

 

Scott Kimball (49:08):

And if you believe that you're an investor that's supposed to be 50 50 or 60 40 don't let the very low bond yields cause you to change your allocation in and of themselves. Understand that the diversification that exists in fixed income and core bond portfolios versus versus other asset classes is the primary reason why you own the fixed income portion and that yield is a bit of a secondary consideration for more investors than they've been then than they think. Then they probably would would describe themselves at least. So big takeaway, volatile market declines in risky assets, exceptionally low bond yields. Yes, these are all individual outcomes of the markets, but the inertia of these asset classes and the way they behave in these markets should only reinforce the decision of why you picked your asset allocation more so now than ever in the past.

 

Rick Unser (50:06):

No, very well said. And as we kind of wrap up here, obviously we're living through some pretty crazy unprecedented, I feel like that word's getting a little overused, but anyways, what do you think needs to happen or what would you be looking forward to in the months that might help restore order? Is it just, is it just more data? Is it any type of government in our intervention or I guess what helps restore us back to some sense of normalcy where the market's not going up and down two, three, five, 8% in a given day.

 

Scott Kimball (50:49):

I think first and foremost, I think you're going to see the, the federal reserve surrender to the treasury market and move their fed funds rate back to basically recovery policy of call it, you know, zero to 50 basis points that they're going to land somewhere in there consistent with where front end yields are. You're, you may even see zero to 25 like we did in the financial crisis. That's not to say that the fed believes you can fight a virus or oil prices with interest rate policy. That's, that's we, that's not what the fed believes that we don't believe that's in any way shape or form how they're reacting or what they're reacting to. But this is more of an acknowledgement of where treasury yields have gone and that they need to keep markets credit markets in particular functioning so that a potentially mild recession doesn't become a really bad one.

 

Scott Kimball (51:42):

So we think some pretty aggressive action from the fed is looming. You may see them also stop the balance sheet runoff, which will probably help the MBS mortgage backed security market and lend more support there. Not that it's not well supported, but it can help sort of calm risk markets and sort of push investors to start stepping back into corporate bonds and high yield. So the fed is one angle. The other is we do believe there needs to be and will be some sort of bipartisan support for fiscal stimulus if they fight over that and make it a part as an issue. Unfortunately, I think markets are gonna are going to bear the brunt of that, but we don't expect that. We think that universally helping the, the, the citizens in this country and with some sort of a unilateral action on the fiscal front can sort of spur household spending.

 

Scott Kimball (52:32):

So any money that has not been spent on leisure and travel can be, for example, it can get diverted into other areas of the economy to keep the growth trajectory going and encourage small businesses in particular to, to keep hiring people. They were doing a great job. Small business was really starting to, has been thriving with starting to thrive even more, almost at unprecedented levels. Let them continue their, their positive momentum. Those would be two catalysts to to help sort of calm the market. The real thing that's going to that about 2020 is if we can get coronavirus under control. We're up against the election cycle. This is going to be a year with some bumps in it. Investors have taken some bruises early. We don't think that by the end of the year we're going to talk about 2020th some watershed year where things were as bad as 2008 I hear that comparison a lot.

 

Scott Kimball (53:19):

We're not ready to cross the bridge to saying this is a 2008 type economy or event 2008 you were talking about a systemic failure of the U S and global financial system. We are nowhere near that. So I would tell people for now to put that out of their minds doesn't mean 2020 is going to be a smooth year for everyone. It started off pretty rough but light at the end of the tunnel. We think at the by the end of the year between monetary and fiscal stimulus and our rather robust global health community. And partnerships will give us some positive direction on the coronavirus issue and get things calmed down. It may not be a year of, you know, we've been gotten used to these V-shape recoveries. Pretty unlikely given all that the market's digesting at the moment, corporate bond corporate earnings would have to, would really have to surprise to the upside now in the second half of the year to get equities to be, you know, strongly positive for the year. Similarly to, to high yield bonds, you have to see a pretty strong recovery to get those higher single digit type numbers that we kinda got used to out of out of high yield. So all things considered, you know, 2020 things will settle down. We will see some positive direction on the the stimulus and recovery side. Do we get back to where we started? Probably not.

 

Rick Unser (54:43):

All right. Well I like a, I like a good dose of realism in reality there. So thank you for that. We've covered a ton of ground. I guess before I let you go, is there anything on your mind that we haven't talked about or anything that you think would help those people in the 401k world, digester or understand some of what's going on now or could be transpiring down the road?

 

Scott Kimball (55:10):

You know, the, the big thing that we've talked about and I just, I'll just reiterate, is, you know, this is one of the markets where you're tempted to do away with an asset allocation model and just use a single data point such as bond yields and let that dictate your entire decision. I wouldn't do that. If you have an asset allocation that you've believed in or that you believe is appropriate for you over the longterm, this is a great opportunity to rebalance. If your fixed income fund has done well and gone from 40 to 45 or 50% of your portfolio against equities, don't be slow to rebalance you. If you have a discipline that says, every quarterly, every quarter we rebalance. There's a reason why financial literature is as has overwhelmingly supported this idea. This is a market to stay focused in your asset allocation, you know, yes, rebalanced as appropriate, but you know, we're tempted, we're always tempted to change our, our asset allocations and our investment strategies in these types of markets.

 

Scott Kimball (56:11):

And it tends to be because of one factor that leads us to that decision. It could be volatility, fear of further loss is low bond yields, rising interest rates. When we do that, we let one dictate our entire decision. And the reality is markets, as we've talked about to this call, there's so many factors that we can ascribe to why market outcomes occur that we can't allow a one factor decision to influence our multi-factor portfolios. This is sort of the level the cooler heads will prevail type of market. And that's really what we're, we're harping on and what we're really advising our clients on the fixed income side to do is if you own fixed income for a reason. And that reason has not changed.

 

Rick Unser (56:56):

Well said and I think some really good food for thought there as we sign off. So Scott, really appreciate everything you shared today. This was awesome and certainly hopefully under different conditions, but we'd love to have you back down the road.

 

Scott Kimball (57:13):

I appreciate it, Rick, as always, and thank you as well to the listeners for your audience, for tuning in, it's a great opportunity for us to share our views with the market and investors broadly.

Recap, Highlights, and Thoughts

Volatility, is an understatement when describing current conditions in the financial markets. To help interpret some recent events and offer thoughts on where we go from here, I am excited to welcome back Scott Kimball, Portfolio Manager with BMO Asset Management. During our conversation he shares very level headed thoughts on what triggered one of the quickest corrections in the stock market we have seen, the rationale for the rapid decline in interest rates, the driving force behind a fall in oil prices, what politics has to do with all this and how could we not talk about the impact of the Coronavirus or COVID-19. Also, be sure to stick around for his wrap up as he shares his thoughts for 401(k) plan sponsors and their employees. 

Before we get started, if you have been enjoying the podcast, please take 30 seconds and leave us a rating and review. The easiest thing to do is go to Apple Podcasts, search “401(k) Fridays”, scroll to the ratings and review section and tap on that, select a star rating, leave a short review or comment and hit submit. Thanks in advance, this goes a long way to help more people discover the podcast.

Thanks for listening!​​

Sincerely Your Host, 

Rick Unser

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