Be Prepared

February 8, 2021

Doug Drabik discusses fixed income market conditions and offers insight for bond investors.

Certain events or comments send the markets into action. It could be a recognized municipal expert forecasting a wave of municipal failures causing investors to panic and sell credits that never wind up defaulting. It could be economists predicting higher interest rates as they have at the beginning of nearly every year for decades. The forecast implores investors to shorten up (lower durations) and keep liquid in order to hold off on purchasing until the moment of higher rates. In actuality, interest rates have generally fallen for over 39 years. Duration should have been embraced instead of being lowered.

To further compound the issue, expectations do not need to come to fruition and the underlying fundamentals don’t necessarily need to reflect anticipation in order for investor sentiment to dominate market direction. If enough people believe in something or react to something, it can move markets. Look back no further than last week’s GameStop rally. A company that is struggling financially is moved to extreme market highs based on off balance sheet factors. Irrational behavior can last a lot longer than most investor’s solvency.

The medical pandemic of 2020 pushed us into a financial recession. The last four GDP year-over-year prints were 0.3%, -9.0%, -2.8%, and -2.5%. GDP measures the total final market value of the goods and services produced. The data release reveals the change in value, not the nominal dollar value. Since we had 3 negative prints, it is likely that the change in value will reflect a very positive number. Note the last couple of times we were in a recession, the following reflected a stronger GDP. A majority of the time, two years after a negative print, GDP YoY snapped back.

Many pundits are calling for higher inflation. PCE just went from 1.37% (Nov) to 1.45% (Dec). Higher inflation but not high inflation. We could have yet another higher print for January and still not have high inflation, yet if investor sentiment views this as a sign of runaway inflation to come, the market may react as such.

First, there is no guarantee that just because it happened before, that this time will follow suit. It stands to reason though, that when you have a very low number, the percent increase will be relatively large. Finally, be prepared. Market reactions are often irrational given the actual underlying data. If investors are emotionally swayed or convinced that a directional move is forthcoming, that snap reaction can carry market momentum for long periods of time.

Being prepared to take advantage of momentary emotional market moves may allow you to gain a little yield advantage when every extra basis point counts in this yield challenged environment. Market emotion has proven to be a worthy consideration in tandem with actual fundamentals. Be prepared to evaluate both.