Time to Go Long
Doug Walters
There has been a significant move toward money market funds in recent months, but it may be time for long-term investors to extend duration.
Contributed by Doug Walters , Max Berkovich , David Lemire , Eh Ka Paw
There has been a considerable inflow into money market funds in recent months. We have talked about the “risk of de-risking” in previous editions. This is the idea that long-term investors have to be careful not to jeopardize their investment plans by swapping equities for money market funds. Today we take another look at money market funds, this time from a duration perspective.
We throw around the term “duration” often when talking about bonds. See our special section below, providing some insight on the subject. But suffice it to say the more duration you have in your portfolio, the more interest rate sensitivity you will have. If interest rates rise… the value of higher-duration portfolios will fall more. When interest rates fall… higher-duration portfolios will increase more.
Money market funds are extremely low duration. Because the Fed has artificially propped up short-term interest rates, short-term money market funds are earning very attractive yields… upwards of 4%+. There are two problems:
- These rates will fall in lockstep with the Fed reducing interest rates. That day will come. The roughly 1% return money market investors earned in the first quarter could fall meaningfully by the fourth quarter if the Fed needs to defend against recession.
- In addition, because of their short duration, money market funds will receive little-to-no market benefit from falling interest rates.
Money markets have their uses, but for long-term investors, we see opportunity at the other end of the yield curve in long-term bonds. These high-duration securities are generally not yielding as much as money market funds, but:
- They will likely appreciate in value if and when the Fed drops rates, and
- Their yields will likely not fall in lockstep with the Fed, so they may remain higher for longer than money market yields.
If you want to capture some extra yield on your cash by allocating some of it to a money market fund or other higher-yielding vehicles, that could make a lot of sense. But, for long-term investors with a well-diversified portfolio, we believe now is the time to extend the duration of your bond holdings, not shorten it. Afraid of a recession? Historically long-term bonds have been one of the best-performing asset classes in a recession and have far outperformed their money market peers.
Duration is the Balancing Point
We talk a lot about duration with respect to bonds, which is not to be confused with maturity. Here we show an example to provide some intuition. Think of duration as the balancing point for bond cashflows. For a bond with a five-year maturity, like this one, the duration would be roughly 4.5 years to keep the cashflows on the left in balance with those on the right. If the bond had higher coupon payments, the “weight” on the left would rise, and the duration would need to shift lower (to the left) to stay in balance.
Acronyms of the Week
GDP and PCE
Ahead of next week’s highly anticipated Fed meeting (aren’t they all), two key reports point to near certainty for another 25-bps rate increase. GDP growth came in at 1.1%, quite a bit below the previous quarter. For much of the past year, economists have considered recession a question of when not if. Now they are dialing in their predictions for its onset in the second half of this year. Most think it could be shallow, but still…
Our second acronym is the Fed’s preferred inflation measure, the personal consumption expenditures (PCE). This month’s headline reading showed a nice decline in inflation pressures. But the Core PCE showed more modest declines and confirmed expectations for another rate increase.
With that rate increase “baked in,” markets most likely will shift focus back to the “how high and how long” question. Post-meeting, markets will be watchful for indications of how the Fed is assessing risks in the banking system and the potential for more “shadow hikes” if banks restrict lending aggressively.
The Week Ahead
May starts with a holiday overseas and an exciting week in financial markets. Apple’s earnings should be the biggest newsmaker. But with The European Central Bank and The Federal Reserve facing rate decisions and an April jobs report on Friday, earnings will take a backseat.
Banking on it!
Markets have had a good amount of data to evaluate, and the consensus is Chairman Powell will announce a quarter of a percent hike.
- The rate decisions will not be the main course as all eyes will be focused on what comes next. Is this it for hikes?
- The appetizer will be what the regional bank failures have done to influence the central bank’s view on its policy tools and regulatory powers.
Continental Breakfast
After the Federal Reserve decision, the baton will be passed to the European Central Bank (ECB) the following morning.
- With inflation still reading much stronger in the old world, the expected rise of either a quarter or half of a percent is not expected to be the last.
- Market implied odds going into a holiday weekend are 70% that it will be a quarter percent hike.
- There is a flood of data, especially inflation data, on Tuesday morning, which can move those odds.
Earnings Crescendo
With a hoard of the mega caps reporting the previous week, the stage is all Apple’s this week.
- There are still a few bellwethers that report this week, like CVS Health (CVS), Qualcomm Inc. (QCOM), Berkshire Hathaway (BRKA, BRKB), Pfizer (PFE), and Starbucks Corp. (SBUX). But the biggest company in the S&P 500 will put a stamp on first-quarter earnings Thursday evening.
- Apple, at $2.6 Trillion market capitalization, is now roughly 7% of the S&P 500 index and a global gauge of consumer demand for “things.”
- Analysts expect revenue for the quarter to come in at $93 billion, a 4.4% decline from the same quarter last year, with earnings dropping 6% in the same period.
May It Be So!
May Day, or International Worker’s Day, is a bank holiday in many countries worldwide. Cinco De Mayo is observed widely in Mexico and U.S.A. At Strategic, May 4th is the holiday held in the highest regard.
- Unfortunately, the U.S. stock market is open on all these holidays.
- May the Force be with you!
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