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A Hidden Menace
Plus October Market Report

John Gorlow | Nov 12, 2018

October was the worst month in six years as global stock prices plummeted. Many investors are now bracing themselves for stormier weather ahead. And yet for all the focus on stocks, bonds could wreak even more havoc. Janet Yellen, former Chair of the US Federal Reserve, recently warned of “systemic risk” in leveraged corporate debt products—risk that would be greatly magnified by an economic downturn. Are we looking at a repeat of 2008, when irresponsible lending practices decimated the global economy? We’ll share insights and advice after a review of October markets.


 October Market Report


October was a brutal month for the markets as stocks and bonds were under pressure. The month’s sharp declines erased the solid gains major indexes had accumulated since their February 2018 low. Concerns that the US economy is in danger of overheating pushed up bond yields. Signs of slowing corporate growth, along with ongoing trade tensions between US and China, added to investors’ worries.


The rout left Global Equities, as measured by the Morgan Stanley All Country World Index, down -7.5%, its worst monthly performance since 2012. The broad US market, as measured by the S&P 500, lost -6.94%. Shares in Europe, as measured by the MSCI European index, declined -7.63%. The MSCI Pacific Index fell -8.5% and the MSCI Emerging Markets index dropped -8.71%.


US Real Estate securities fell -2.5% for the month, bringing the YTD return into slightly negative territory. International REITs fell -4.5%, lowering their YTD return to -7.25%. The 10-year US Treasury bond closed the month at 3.14%, up from last month’s 3.06%. Oil decreased to close at $64.96. Gold closed at $1,217.10.


Despite the turbulence, it’s important to keep October’s losses in perspective. Over the trailing two years, annualized returns on US equities as measured by the S&P 500 Index are up 15%, and the MSCI All Country World Index is up 10.7%. This points to the value of holding equities through all kinds of market noise.  


Feature Article

Of Bonds and Bears


Stocks have historically paid a higher premium than bonds, and investors know to expect occasional volatility. But bonds? Aren’t they supposed to be safe? Depends what kind of bonds you’re talking about, as we learned a decade ago during the mortgage meltdown precipitated by deeply leveraged bond portfolios. That’s why it’s worth paying attention to alarms being raised now by seasoned bankers and economists. Their concern: overleveraged corporate bond portfolios could lead to rippling, large-scale losses when the next recession hits.


There’s a perfect storm brewing: a growing mountain of corporate debt, “huge deterioration” of loan standards (Yellen’s words), and return-seeking investors snapping up low-grade, undercapitalized loan portfolios. These packaged loans can contain just about anything: auto loans, mortgages, credit card debt, receivables, student loans, or corporate debt. Leverage is added to the package in an effort to amplify returns.


The loans are rated according to risk, then sold to institutional funds including pension and endowment funds, and to retail investors who purchase them through mutual fund and exchange traded fund (ETFs) products. Problems arise when the structures aren’t adequately collateralized or strictly regulated. After the crash of 2008, regulators cracked down on banks for their aggressive lending practices. Banks became skittish about lending and tightened their own loan requirements out of self-interest. This had the effect of shifting risk that was once carried on the balance sheets of banks out into the general market.


Meanwhile, the sun still shines (mostly) and the market for these packaged loan products keeps on expanding. After hitting a high of $650 billion in new issues in 2017, the market now exceeds $1 trillion. What could bring this party to an end? The same things that always bring the party to the end. A cooling economy. Rising interest rates. Unsustainable debt. 


The “systemic risks” Yellen and others warn about could play out as a rush-to-the-exits scenario, as deteriorating credit quality causes investors to bail out, forcing the sale of illiquid bonds. Because more than half these bonds have a low BBB rating, just above junk bonds, a credit downgrade would also force investment-grade owners to follow suit.  


Should these things come to pass, you’ll hear a lot of talk again about the evils of overleveraged corporate bond packages. But this time, banks won’t be left holding the bag. And the investors who are holding the bag won’t have the federal government to bail them out.  If there’s a run on these loan packages, large institutional investors and millions of individual investors could be on the hook. Corporate bankruptcies would increase, perhaps even skyrocket as the leveraged corporate debt market collapses. As the mortgage crisis demonstrated, the pain would not be confined only to those affected by bond losses. The ripple effect could be substantial.


Let’s return to where we are today, near the end of 2018, ten years after the onset of Great Recession. The long era of low, post-recession interest rates that drove investors to equities also drove equity prices to record levels. But the feeding frenzy is subsiding as interest rates move higher. Equity prices are stabilizing or falling, and concern over a slowing economy is rising. Economist Martin Feldstein offers this bearish scenario (WSJ, 27-September 2018): “If the P/E ratio of the S&P 500 regresses to its historical average, 40% below today’s level, $10 trillion of household wealth would be wiped out.” Consumer spending would decline, business investment would plummet, and GDP could drop as much as 2%, Feldstein suggests. And with interest rates already low and a federal deficit that’s skyrocketing, the Fed would have little power to use its traditional tools of rate-cutting and fiscal intervention. This could spell an ugly, prolonged recession.


No sane investor would want to be left holding low-quality, risky corporate debt should this happen. Of course, there’s no certainty it will happen. “Economists have predicted nine of the last five recessions,” as the saying goes. But the present environment leaves many in a quandary. How can investors achieve growth or income without taking inappropriate or foolish risks?


Most investors choose to take risk on the equity side of their portfolios, not the income side. This is not to say you should never take risks with income investing, only that you should know what you’re getting into. If you have questions about your bond portfolio or are contemplating different ways to chase yield, don’t hesitate to ask. We’re here to help you evaluate your options. 


Markets are fickle, and we live in a time of increasing uncertainty and rapid change on many fronts. This is all the more reason to hold a diversified portfolio based on your personal risk tolerance, goals and time horizon. Stick to strategy, even if it’s frustrating or nerve-wracking at times. Leave bond-market roulette to others. 


Do you have questions or concerns? Call me, I am here to help.


John Gorlow President
Cardiff Park Advisors
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jgorlow@cardiffpark.com