Market Euphoria Fades

After each European summit, investors respond as if they’ve heard “the boy who cried wolf.”

By Greg Sweeney, CFA, Chief Investment Officer, Bell State Bank & Trust

When something round is in motion, like a tire rolling down the road, it is hard to tell the beginning from the end. During a wedding ceremony, the presider may comment that a ring has neither a beginning nor an end. Philosophically, anything round has no beginning and no end.

The common European currency has a beginning – but the discussions about how to fix its current problems seem to have no end. Summits aimed at “fixing” Europe’s banking, government debt, austerity measures, economic slowdown and other issues are increasing in frequency but not effectiveness. Market euphoria fades more quickly after each summit, with investors starting to respond like the villagers in the fable about “the boy who cried wolf.”

Growth Expectations

Growth expectations in Europe and China are coming under pressure. Expectations for U.S. economic growth in 2012 are drifting downward from 2.5% toward 2%. This is supported by the fact that real personal income has remained flat for several years now. It is hard for the economy to grow when income has stalled and additional personal debt is either unobtainable or not palatable.

Limited growth, European issues, U.S. Federal Reserve monetary programs, our country’s deficit spending, growing tensions with Iran and a host of other factors slowly drain investors of enthusiasm. The psychology of wanting to preserve investment principal has helped drive interest rates continually lower. U.S. Treasury bonds used to be considered “risk-free return.” Today, Treasury interest rates are so low, especially after inflation, that they could more accurately be referred to as “return-free risk.”

Growing Concern

Our concern is that investors look at popular long-term bond funds and see stock market returns without the stock market risk. Stocks get a big part of their return from rising share prices and a small portion from dividends. Bonds traditionally get a big portion of their return from interest income and a small portion from rising prices. Unfortunately, bonds have a maturity date; any increase in price fades away at maturity, and the investor’s return is the interest income. If a ten-year Treasury bond is purchased today, the interest income is 1.6% annually for the next 10 years. If interest rates decline to 1%, an investor who owns that bond would open his or her annual statement and see about 7% return for the year. That is quite a difference from the 1.6% interest income. To get this return, the bond needs to be sold. Once the bond is sold, the proceeds would be reinvested in the new interest rate environment of 1%. The generous return in the first year is simply the present value difference between 1.6% interest income and 1% interest income.

We are concerned that the bond market has created a false sense of return and continues to draw unprepared investors into the asset class. Rising interest rates erode the value of bonds. While this is not the case today, if it occurs, investors will be stuck with low interest rates for longer than they expected.

We believe our fixed income responsibility is to balance yield, principal security and maturity structure to provide interest income and flexibility. Our goals are to preserve principal, provide income and maintain the opportunity to reinvest in future environments that may be more favorable to our clients. The lower interest rates go today, the higher that probability becomes in the future.

Thank you for your business and for your confidence in Bell State Bank & Trust.

If you’d like to talk more about investment scenario planning, call Greg Sweeney to start the conversation.


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