Bonds Continue to Surprise and Confound

Portfolio Coordinator’s Report for June 2021
Ray Munsch 7/11/21

The primary portfolio change since our last Board of Managers (BOM) meeting in April has been the implementation of the alternative fixed income strategy that was approved for 5% of the portfolio:  2.5% to be invested in the Vanguard High Yield Bond Fund (VWEHX) and 2.5% in a laddered maturity strategy using exchange traded funds (ETFs). They have now been fully implemented for several months.  It is much too short a period to make any judgment about how the new strategies are performing.

US StocksITOT, FSKAX52%60.00%62.79%
Non-US StocksIXUS,FSGGX13%10.00%9.89%
Total Stocks65%70.00%72.67%
Inv. Grade BondsVCIT35%22.00%21.93%
Alternative FixedVWEHX, Laddern/a5.00%4.95%
Total Fixed35%27.00%26.88%

While on the topic of fixed income, the surprise, at least in my opinion, over the last three or so months has not been the performance of the stock market, which is making new highs on almost a weekly basis, but the performance of bonds.  At the end of the first quarter, the 10-year Treasury bond (which many people use as a proxy for the bond market) yielded 1.73%, having risen steadily from a low of 1.02% just two months earlier.  The fear of investors during this period was that inflation was going to return on the back of strong economic expansion, pent-up consumer demand, central bank largesse and supply chain bottlenecks.  If this were to occur, it would be bad news for fixed income participants, and the market acted accordingly as reported inflation numbers seemed to support the worst fears.  On April 20th, when we last met, the 10-year Treasury yielded 1.60% and on May 12 it was 1.70%, near its high at the end of March.  Then, a funny thing happened.  As if to confound everyone, yields started to decline and continued to do so throughout June and early July.  Now, on July 8th, the 10-year yield stands at 1.29%.

What does the action of Treasury yields tell us?  Perhaps, the Federal Reserve officials and others in their camp are right.  The rise in reported inflation this spring and early summer are only temporary as the economy snapped back from the Covid-induced weakness of a year ago.  The contrarian argument for yields falling is that once the effects of Covid-related stimuli run out and pent-up demand is satiated, the underlying economy remains weak and/or there is a growing risk of a Covid relapse.  

My suspicion is that in the months ahead the smart money will be paying more attention to how things shake out in the bond market than to which stocks or stock sectors are setting new highs.  Until the Fed signals a shift in its interest rate policy or bond buying policy, it is difficult to make a case for a major stock market correction despite historically high valuations.  I often muse that the Fed has boxed themselves into a corner and has no viable avenue of escape that will not unsettle the capital markets.  Perhaps the role of consumers really is to simply consume and not save.  Put everything on credit and hope the Fed keeps interest rates near zero.

As far as the EEF is concerned, total assets are about $1 million higher than they were in April.  The only extraordinary inflow or outflow during the period was a relatively small outflow in June.  As of the close of business on July 8th, total stocks stood at 72.67% of the portfolio, shy of the upper tactical range of 73.00%.  Total fixed income was 26.88% of the portfolio, slightly below its tactical target of 27.00%. Stocks are 54 bp higher than they were at the April meeting and bonds are 73 bp higher.  Cash has declined to 0.44% of the portfolio from 1.72% previously.