29 Jul

EPIQ Blog: It is the Best of Times...

This quarter we revisit a theme on which we opined in early 2015 titled "The Tale of Two Markets." Fast-forward 18 months and the situation has only magnified with bond yields continuing to fall, suggesting an anemic economic outlook, and stock market valuations priced in anticipation of continued earnings growth. What's the problem? Both schools of thought cannot be right at the same time.

The exhibit above graphs the yield of the overnight Federal Funds (FF) rate, the interest rate banks charge one another for short-term funding. We use this as a proxy for the risk-free rate off of which investment returns can be measured for assuming additional risk, such as credit, liquidity or term.

The average FF rate over the last 60 plus years has been approximately 5%. During that same period equities, as measured by the S&P 500 Index ®, returned an annualized 10.5% or a 5.5% premium for assuming greater risk. In other words, investors received double the annualized return of the risk-free rate for investing in stocks.

For the last decade the FF rate has been near 0% in spite of the desire by many for a more "normalized" environment. In fact, today, there are approximately $10 trillion in global bonds that trade with negative yields. This figure is up substantially over the last year making it common for purchasers of bonds from Japan, Germany and Switzerland to actually pay interest to loan money to these governments.

Many interpret this condition as an ominous sign for future returns as global economies struggle to expand at growth rates we grew to expect. The accommodative monetary policies do not seem to have produced the kind of growth everyone had hoped for. However, they have inflated asset prices.

The investment universe appears to have flipped over the past 18 months. Government bonds that provide steady income and cushion the volatility of a stock portfolio have appreciated significantly. Moreover, bonds have delivered three times the total return of stocks over this period while a broad basket of stocks have delivered greater income from dividends. This peculiar situation where the yield on the S&P 500 Index is greater than the yield on the 10 Year US Treasury has only appeared a couple of times in the modern era and both times resulted in solid gains for stocks in the ensuing period. Unfortunately, traditional stock valuations were far more reasonable in those previous occurrences. The market has taken note of recent events such as "Brexit" and decided these low-rate, no-rate and negative-rate scenarios will continue.

Our expectations for returns moving forward remain muted for both stocks and bonds. We believe the U.S. remains the best place on the globe to deploy capital. In spite of the upcoming elections, the uncertainty surrounding the U.K. leaving the E.U. and the never ending conflict occurring in the Middle East, we continue to benefit from a culture and system that fosters innovation and rewards individuals and companies for taking prudent risk. The issues of the day change, but the opportunity to develop innovative products and services still exists and this is what will help drive growth in the U.S.

EPIQ Happenings

We are thrilled to announce that Ben Frey has joined EPIQ Partners as Director of Investment Research and Portfolio Administration. A graduate of Willamette University, Ben joins us with extensive industry experience that will enhance our ability to grow and deliver value to all of our partners.

Lastly, SAVE THE DATE: October 5th, 2016. The EPIQ Clambake will be held starting at 4:00 PM at the Bakken Museum on Lake Calhoun. Great food and refreshments with a healthy dose of interesting people and conversation. Contact us for details.

Thank you and call on us to continue the conversation.

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