- Monthly portfolio update: Fairly stable month: bonds down on Fed policy shift, but offset by K-shaped recovery in stocks and commodities
- Book tip: The Everything Bubble: The Endgame For Central Bank Policy by Graham Summers (link at the bottom of the post)
- In case you missed it: I have ditched all intermediate-term bonds (post from 3 August 2020)
- Coming soon: a post on real estate investing and how it fits in the All Seasons Portfolio. Stay tuned, and subscribe to newsletter for notifications!
I hope you have had a great summer under the circumstances, and are ready for the next (non-economical) season!
When posting this article, I have just come home to Sweden after a few weeks of visiting my girlfriend’s family in Italy. For sure, the virus has put a great strain on the country, but it is good to see that things are moving in the right direction with society opening up. With few exceptions, new cases have been declining in Italy and Europe, which has bolstered investors with renewed confidence the past months.
Our vacation this year was not as we had initially planned (beaches in Sicily), but of a less touristy, and much more responsible, sort. Instead, we have stayed with her family and taken a few day trips to selected non-crowded destination (Venice has not been this empty for centuries). While more and more flights are opening up across Europe, it is still important to be cautious and not take unnecessary risks. One should not think that the danger is over, just because travelling is again somewhat possible. We can just hope for a full recovery as soon as possible.
But this is not a travel blog, but a financial blog, even though I wish to one day be able to sustain a life abroad thanks to my finances.
Credit Ratings and how Covid-19 may impact them
In this light, I have lately been thinking about how Covid-19 has affected the financial stability of countries, and how that in turn will impact sovereign credit ratings. For example, if debt-to-GDP would increase too much, if the affordability of the debt would fall, or if the economic outlook or stability of a nation would decrease, it will impact the country’s ability to service its debt.
The ability to service debt – or a sovereign state’s credit worthiness – is what the credit rating agencies Fitch, Moody’s and Standard & Poor, are all analysing and rating. If a sovereign state has a good credit rating (AAA, Aaa etc.), this gives great comfort to the investors who purchase the country’s bonds that there is a low risk of that the state defaults on its debt.
The credit rating also is a risk gauge for the bonds. With a higher rating, and thus lower (assumed) default probability, the lower risk premium is paid for holding the bonds. Thus, yields will be kept lower for highly rated issuers, and will be higher for issuers with lower credit rating.
This also means that if a state would be downgraded by credit agencies, for example as a result of pressure on the economic outlook caused by Covid-19, this will impact the yields of the outstanding bonds issued by that state. Because the credit rating is a measure on default probability, with a downgrade, the risk for the bond has increased. A downgrade will directly affect the yields on the bonds when a higher risk premium is discounted, and the value of the bond will decrease.
Why is this relevant for an investor?
In the All Seasons Portfolio, bonds issued by sovereign states take up 55% of the portfolio. For me, those 55% are split between 40% Long-Term U.S. Treasury Bonds, and 15% U.S. Inflation-Linked Bonds (TIPS). Bonds are held as a hedge against lower economic growth, as yields will generally fall when investors seek lower risk investments.
In June, Moody’s published a report on their view on the Covid-19 impact on the credit ratings of major economies. It is a short and good read (7 pages), but you may need to register for a free account to be able to access the report. Moody’s concludes that the pandemic will markedly increase the debt burden of advanced economies, and their maintained credit ratings are contingent on their ability to reverse the debt trajectories as soon as possible after the crisis. Of the analysed advanced countries, the United States is in the worst position when considering debt affordability (cf. page 5).
What does this mean? It means that the countries that will not be able to 1) increase their GDP, 2) decrease their deficits, and/or 3) maintain strong debt affordability, will be at risk of having a negative economic outlook, and thus risking being downgraded. For example, Fitch downgraded Italy to BBB- in April following the shock that the coronavirus had on its economy, which is just one notch above junk.
|Issuer||Fitch||Fitch Outlook||Moody's||Moody's Outlook||S&P||S&P Outlook|
|Ratings as per 4 Sep 2020|
How does downgrades impact investors using the All Seasons Portfolio strategy?
As just discussed, when the perceived risk for default of a government increases – a perception that can be confirmed by a rating agency downgrade – is very likely increase yields of the issuing country’s outstanding bonds. Such downgrades are more likely during times of increased levels of distress, putting greater strain on the sovereign’s national finances.
As long-term government bonds are included in the portfolio as one of several hedges against lower economic growth, they may not be able to fully offset all challenges of a negative environment if the economic crisis causes a strain on the bond issuer. It does not necessarily mean that bonds are useless as a hedge, as they are likely to perform much better than stocks under such circumstances, but it is wise to bear in mind that credit ratings will impact the value of your bonds.
So what to do? I think it may be wise to 1) be aware of your geographical exposure and the outlook for credit ratings, and 2) diversify issuing countries of government bonds.
For example, my bond part of the portfolio is 100% allocated to the United States, which, traditionally, is a strong economy and the home of the world’s reserve currency. But it is not immune to downgrades, as was very evident during the great financial crisis of 2008. Moreover, as late as on 31 July 2020, Fitch changed the outlook of the United State’s credit rating to Negative from Stable (while maintaining its AAA rating). Read this together with the Moody’s report I linked to further above, and you can see a trend on where we may be heading.
What will this mean for me? I will keep an eye out for further signs on the development of the health of the American economy. It is however not as simple as reading if the U.S. GDP would fall further or if the deficits would rise. It gets more complicated to predict downgrades because the economic health of a sovereign when determining credit rating is relative to that of other nations, as affirmed by Fitch in a recent article:
“Rating changes also need to account for not only absolute deteriorations in credit metrics but also sovereigns’ relative changes.”Fitch, 25 August 2020
This means that even if the health of the United States’ economy deteriorates, it may still maintain its current rating if the economies of peer nations perform similarly.
All this considered, if I see signs that may increase the probability of a downgrade of U.S. debt, for example, GDP numbers, increased deficits, or further large stimulus, I will sell my IS04 ETF (iShares $ Treasury Bonds 20yr+ UCITS ETF), and instead buy a global long-term treasury bond ETF, for example the iShares Global AAA-AA Govt Bond UCITS ETF (IS0Z). The risk of being exposed to only one country may be too high.
(The main difference between the iShares Global AAA-AA Govt bond ETF and a European equivalent ETF like the Xtrackers II Eurozone Government Bond 25+ UCITS ETF for example is that you also gain access to sovereigns such as Sweden, Denmark, Unite Kingdom, United States, Australia, New Zeeland, and Canada, but not to Italy, which, as disclosed in the table above is rated below AA).
This ETF includes bonds issued by several European governments. I would still have exposure to the United States, but to a much lesser extent. Moreover, there is of course the risk of the other governments being downgraded as well. In a global crisis, which this may turn out to be, no one country is likely to be 100% safe.
And in any event, if the shit hits the fan (in the lack of a better expression), bonds issued by downgraded sovereigns are likely to still outperform stocks by a lot. Thus, the theoretical protection against lower economic growth provided by government bonds will remain.
I would love to hear your thoughts on this topic and how you have positioned your bond part of your portfolio in the light of the credit worthiness of the issuer. Happy to discuss in the comment section.
Portfolio Update August 2020
While it is on my radar to perhaps change focus with my bonds in the future depending on the development with respect to credit rating, I have yet to make any adjustments in my portfolio. Thus, during August, my portfolio stayed the same.
In case you missed it, I have ditched my mid-term bonds which I wrote about in a post from beginning of the month. Here I discussed further why I had sold my intermediate-term bonds in July and switched solely to long-term alternatives.
As a heads-up, I have another Deep Dive post lined up, where I will be discussing real estate investing and how that can fit into a balanced portfolio with respect to risk and seasons. I am planning to publishing it next weekend (around August 13th) so keep an eye out, and make sure to subscribe to the newsletter to get a notification as soon as new posts are made available.
What has happened on the markets during August?
On the stock markets, a new letter for describing the recovery has been launched, namely “K”(in addition to the V, W, U, L shaped potential recoveries). The K-shaped recovery describes the very different outlook for companies that have benefited from the pandemic (tech stocks such as Amazon, Alphabet, Zoom, etc.) and those that have been hit hard (cyclical companies in for example manufacturing). While the S&P 500 index is now above where it started the year, this has been driven by a very small amount of companies (mainly the FANGMAN companies) while other companies have not seen the same development in their share prices. At the same time, the economic growth is still expected to lag far into at least 2022, and is much dependent on the severity of a second wave.
Commodities are still underperforming, but there has been some recovery during the month. Oil, which is the largest component in more or less any commodities index, has not recovered the slump from March and is trading around $45/barrel (Brent). As reference, the price exceeded $65/barrel by February. Manufacturing metals have also lagged as manufacturing has halted, but may see a recovery when big industries are firing up again. At the same time, other commodities have surged. The price on lumber has gone through the roof after a complete miscalcuation by producers who decreased volumes expecting demand to fall. But demand for timber has remained high thanks to a home improvement boom, causing an unbalanced market with too little supply, and a rally in lumber prices to all-time high levels.
Having stretched high above $2,000/oz by beginning of August, the gold price has retreated below the $1,950/oz mark when investors began taking home some of the profits after the rally the past few months. While gold demand from manufacturing (for example for jewelry) has been low, the price increase has mainly been driven by gold bugs and speculators. When the buy side temporarily falls away at the high prices, a set back was expected. It remains to be seen whether this is just a temporary consolidation before further runs upwards, or if the peak is behind us. Much will depend on future inflation of the USD and the strength of the recovery of the economy.
Government bond prices dropped during August following a policy shift from the Fed. Fed’s Jay Powell has communicated a policy shift for the Fed, allowing higher inflation at times. The 2% inflation target will from now on be an average target, meaning that inflation above 2% will be tolerated. Investors have interpreted this move as that rates will be kept ultra-low for longer. This has pushed down the price on bonds, as a higher inflation premium is now discounted for. Higher inflation will erode the real return of low-yielding assets, which triggered a sell-off in 30 year Treasury Bonds.
Prices of inflation-linked bonds, however, were not particularly affected by Fed’s policy shift.
Looking more closely at my portfolio, since my July 2020 update the overall portfolio is more or less similar, but with some shifts between assets. Government bonds have decreased, as has gold, but commodities and stocks have rebounded during the month.
The splits are thus similar, and very close to my aimed allocation. I am still overweight in gold, but I am happy with that exposure as an inflation hedge. Government bonds are slightly underweight, but that has not been harmful, at least considering the negative news from the Fed’s policy shift.
From the below graph, it becomes more visible how bonds have fallen, but that the fall has been largely offset by increases in other asset classes. My total wealth has thus remained intact.
From a year to date perspective, I now start to see convergence between assets after the dramatic moves by March. Stocks and commodities have began recovering, while bonds have fallen back toward pre-crisis levels. The investment into stocks and commodities in April seems to have been a wise move.
Lastly, here’s a view of the ETFs in my portfolio, and the performance of each during the last month, in table form. No new money has been added, nor any other trades conducted.
|iShares Global Inflation Linked Govt Bond UCITS ETF||TIPS||IE00B3B8PX14||€607.76||€599.96||-0.56%|
|iShares USD Treasury Bond 20+yr UCITS ETF||Govt Bond Long||IE00BSKRJZ44||€1,325.94||€1,249.68||-1.10%|
|Invesco Bloomberg Commodity UCITS ETF||Commodities||IE00BD6FTQ80||€320.76||€336.48||4.90%|
|Xtrackers Physical Gold ETC||Gold||GB00B5840F36||€488.91||€481.39||-1.54%|
|Vanguard FTSE All-World UCITS ETF||Equity||IE00B3RBWM25||€1,222.88||€1,291.04||5.57%|
With this update, I would like to thank you for your attention. Remember to keep an eye out on the post on real estate investing that I will be publishing in the next week. It is a lengthy post that I am really happy with, as it covers many aspects of not just real estate, but also how to think when adding other asset classes to your balanced portfolio.
I have also set up a Patreon site, to cover hosting costs, which reach a couple hundred euros annually. If you find any content here at all useful and feel that you can treat me for the equivalent of a double-espresso, read more about what this means on the Support page here on the website. I have a hosting bill of around EUR 140 falling due in November, so any support is extremely helpful, as the monetization of this blog is very limited.
See you again in about a month, and I hope to hear your thoughts on credit ratings in the comment section below.
Until next time, and stay safe,
Book tip: The Everything Bubble: The Endgame For Central Bank Policy by Graham Summers
The Everything Bubble chronicles the creation and evolution of the US financial system, starting with the founding of the US Federal Reserve in 1913 and leading up to the present era of serial bubbles: the Tech Bubble of the ‘90s, the Housing Bubble of the early ‘00s and the current bubble in US sovereign bonds, which are also called Treasuries.
Because these bonds serve as the foundation of our current financial system, when they are in a bubble, it means that all risk assets (truly EVERYTHING), are in a bubble, hence our title, The Everything Bubble. In this sense, the Everything Bubble represents the proverbial end game for central bank policy: the final speculative frenzy induced by Federal Reserve overreach.
The Everything Bubble book is the result of over a decade of research and analysis of the financial markets and economy by noted investment analyst, Graham Summers, MBA. As such, this book is intended for anyone who wants to understand how the US financial system truly operates as well as those interested in the Federal Reserve’s future policy responses when the Everything Bubble bursts.
To that end, The Everything Bubbleis divided into two sections: How We Got Here and What’s to Come. Combined, these sections represent a blueprint for all things finance and money-related in the United States.
For anyone interested in the All Seasons Portfolio and Risk Parity investing, I find this a great read as you enhance your understanding for both the vulnerabilities of the economies (ref. discussion above on credit ratings) and government bonds. Or check out other great books on the topic on the Book recommendation page.
Check it out today on Amazon (affiliate link):