Back to normal: That may be one way to describe the recent volatility in the equity markets, following last year’s unusually steady upward trending stock returns. The CBOE Volatility Index (VIX) had one of its largest increases ever, surging 80% during the first quarter amid investor concerns about inflation, rising interest rates and global trade tensions. Of course, it is that very uncertainty in the day-to-day movement in stock prices that provides the risk premium – i.e., return in excess of the risk-free rate – that investors seek when they invest in stocks.
So what was the market result after all that volatility? The Dow Jones Industrials ended the quarter down 1.96% and the S&P 500 was off 0.76%. Smaller U.S. stocks barely moved during the three-month period, with a +0.08% return, while interest rate sensitive REIT’s (Real Estate Investment Trusts) fell 7.43%. Stocks in the European markets declined along with those in the U.S. The MSCI Europe Index receded 1.86%. Shares in the Pacific markets were down a more modest 0.57%. Among the major equity indices, only the Emerging Markets enjoyed positive returns at 1.47% for the trailing three months.
Contributing to the sense of volatility last quarter was the impact of rising short-term interest rates on Government T-Bills and Notes. While the Federal Reserve influences the overnight lending rate, it is participants in the bond market that set most other interest rates by increasing or decreasing the demand for various bonds based on factors such as credit quality and anticipated inflation. After hovering around 2.4% for nearly all of 2017, the yield on the benchmark 10-Year Treasury increased to 2.96% in mid-February before ending the quarter at 2.74%. The prime rate, the rate at which banks lend money to their best customers, has escalated ¾% over the past twelve months and now stands at 4.75%. The recent increase in interest rates is reflected in the modest losses incurred by most domestic bond funds.
Over the past several decades investors have enjoyed a nearly uninterrupted bull market in bonds. As interest rates declined from their peak in 1981, bond prices have steadily increased such that in many cases an investor’s bond position provided capital appreciation even as its yield diminished. As mentioned above, interest rates have started to climb from their historic lows and bond prices, which move in the opposite direction, have receded. The graph below provides a generalized illustration of a 1% increase in rates on the price and total return for U.S. Treasury Notes and Bonds (UST) and Treasury Inflation Protected Securities (TIPS) at various maturities.
As the graph makes clear, the greater a bond’s maturity, the more susceptible it is to rising interest rates. It is also worth noting that, although bond positions have been perceived as a welcome offset to the volatility implicit in stocks, there have been periods in history when stocks and intermediate-to-longer term bonds have lost value in tandem. We have observed this condition in the first quarter of 2018.