First Quarter 2021 Client Letter

First Quarter 2021 Client Letter

First Quarter 2021 Client Letter


Who Controls Interest Rates?

The critically acclaimed news show 60 Minutes debuted in 1968 using a unique style of investigative journalism that was centered around the reporter telling the story (Wikipedia). Almost 53 years later, the show still brings in strong ratings. At Morton Capital, 60 Minutes used to be a hot topic around the proverbial water cooler (really the coffee machine) on Monday mornings, especially when stories focused on the financial markets. The water cooler may have migrated to Zoom, but the show is still a topic of conversation in 2021’s virtual world.

When Jerome Powell, the head of the Federal Reserve (“Fed”), was on the show in early April of this year, it posed a good opportunity to discuss certain trends in U.S. monetary policy. One of the more insightful questions that came up was from one of our newer team members. Having intently listened to our education sessions for several weeks, this team member was unclear as to how Mr. Powell could claim that the Fed was “highly unlikely” to raise interest rates in 2021 when just weeks earlier our investment team had been presenting on the big rise in rates during the first quarter. To address this disconnect between reality and what appeared on the news, let’s first take a closer look at what has happened to the market over the last few months.

Stocks Continued Their Ascent While Bonds Took a Hit in the First Quarter

The jump in interest rates that our investment team discussed led to a rare negative quarter for bonds in what was otherwise a stellar start to the year for risk assets.

Stocks continued their tremendous run from the lows of March 2020 as the vaccine rollout and projected economic growth accelerated. While there is certainly basis to be optimistic about rebounding economic growth in the short term, by many historical measures, stocks are in dangerously overvalued territory. Recent stock buying has reached a speculative fervor, with investors pouring into stocks at record levels. In the past five months alone, investors have purchased over $500 billion in stock funds, which is more than they purchased in the previous 12 years combined! The types of stocks being purchased are also more speculative in nature, with trading volume spiking dramatically for more risky penny stocks (stocks that trade under $1) and the performance of technology companies with negative earnings meaningfully outpacing their profitable counterparts.

While these trends in stocks are alarming, they are not necessarily new as speculation and risk-taking have been pervasive in stocks for some time. What was new was the meaningful loss in core bonds. While a 3.4% loss may not seem large enough to be labeled “meaningful,” this is an apt description when compared to the potential return on this investment. The Barclays Aggregate Bond Index, widely considered a broad measure of the traditional, or core, bond market with exposure to both U.S. government and corporate bonds, had an annual yield of 1.1% at the beginning of the year. Therefore, that 3.4% loss wiped out approximately three years’ worth of expected returns for investors. And that loss occurred in just three months, with interest rates increasing by only 0.5% for an ending yield of 1.6%. This 0.5% increase is a big move on a percentage basis but would be considered modest on a historical scale. The below chart tracks the nominal yield of the Barclays Aggregate over time and shows just how small this recent increase was when put in a historical context.

What Causes Interest Rates to Change?

So, with the above context, let’s revisit how Fed Chairman Powell could say that the Fed had no intention of raising interest rates while interest rates were already on the rise. While not a widely understood concept, the answer is that the Fed does not have complete control over interest rates. Technically, the Fed only has the ability to set short-term interest rates. It has tremendous influence and can try and manipulate long-term rates, but at the end of the day, long-term rates can be driven by other factors in the broad market.

Let’s explore some of the factors beyond the Fed that impact the direction of interest rates. As a reminder, interest rates are simply the cost of borrowing money from another entity. Low rates typically happen when there is a slow growth economy or even a recessionary environment. In these environments, there will be low demand for borrowing. Businesses will not be eager to expand, and perhaps individuals will not be eager to take on leverage, so rates stay low. So what do banks do? They lower interest rates even further to try to stimulate business and borrowing activity. Governments can also intervene to lower the interest rate targets that they control in an effort to stimulate economic growth.

On the other side of the coin, high rates are typically associated with an economy that is growing quickly. When an economy is strong, there is more demand for businesses to expand and consumers to spend, and this results in a higher demand to borrow. Because of this, banks and lenders can charge higher rates. This is part of the reason why rates have risen in recent months. Forecasts are coming out that economic growth in 2021 may be very strong. While it was expected that economic growth would be positive coming out of the recession we have been in, new expectations are pointing to even stronger growth than previously anticipated.

Another factor that could lead to higher rates is fear of unsustainable debt levels. Our country has been on an unprecedented spending and debt spree to combat the crisis that we have faced. Typically, when a country’s debt levels expand rapidly, as has happened of late, interest rates rise. This is for two main reasons. First, it comes down to the creditworthiness of the borrower. When a country piles on debt to unsustainable levels, a lender or buyer of that debt will demand a higher interest rate to compensate them for the increased risk they are taking on. However, it is almost unthinkable that the U.S. government would default on its debt payments, which leads us to the second reason why interest rates may rise when a country’s debt levels expand rapidly: potential inflation. The U.S. government has both the power of the printing press and the ability to continue to issue new debt to help pay for or refinance old debt. While these powers basically eliminate the possibility of the U.S. defaulting on its debt, the result is increasingly more dollars being printed and increasing debt levels with each passing year. If you are lending money to the U.S. government, this is not a comforting scenario. While, yes, you will get your money back at the end date, or maturity, of the loan, in the time that has passed, how many new dollars have been printed? With all of these new dollars in circulation, the concern is that the value of each of those dollars will erode over time and your future dollars are going to be worth less. Lenders that see this trend should demand higher interest rates to help compensate them for this risk.

Should Investors Be Worried about Inflation?

We have never seen fiscal spending and the issuance of new debt anywhere near the scale of what we have seen in the last year. The cumulative price tag for all the COVID-19 rescue packages issued to date is over $5 trillion and there is talk of another $2 trillion infrastructure package and even more stimulus to come. By the end of 2021, U.S. debt will be around $30 trillion, three times the level it was back in 2008. Not only are debt levels ballooning but the money supply, or amount of money in circulation, has ballooned as well. The below chart tracks the annual percentage increase in dollars that have been created in the last 45 years.

On a historical basis, the annual increases in money supply are almost always above 0% and often close to 10%. The amount of money printed in the past year, however, is unprecedented. This is because the Fed is printing dollars to the tune of roughly $120 billion per month and purchasing our country’s debt to help finance all of the new spending programs. These massive new amounts of dollars filter their way through the economy, and the concern is that inflationary pressure will build. It is pretty simple: more dollars chasing the same assets, goods, and services will result in increased prices. We are already seeing increased asset prices (e.g., stocks and real estate) as a result of these policies, and the risk is that pressures are building so we will see increased prices with goods and services as well.

Morton’s Approach to Risk Management

If a 0.5% increase in interest rates can wipe out three years of returns for the broader bond market, what can investors do to protect themselves? As discussed previously, many investors are pouring into stocks because bonds are so unattractive and they have no real alternative. This strategy comes with a completely different set of risks as stocks continue to reach new all-time highs. Many investors need some component of fixed income in their portfolios to hopefully act as a ballast during periods of market volatility and also to act as a source of liquidity. So as much as investors may want to write bonds off completely as being unattractive, that may not be a viable solution for everyone.

At Morton, we have approached the liquid fixed income space with an emphasis on risk management. We can meaningfully reduce or eliminate our interest rate risk by not investing in bonds with longer-term maturities. In some instances, we can even invest in floating-rate bonds, where our returns will increase as interest rates rise. Certain less traditional bond strategies can also introduce different risk and return drivers from mainstream bonds, offering true diversification benefits for a portfolio. These same strategies often come with higher current cash flow as well, which is welcome in this low-interest-rate environment. These more opportunistic strategies are not without risks, but we feel that they are smarter risks than just sticking our head in the sand with long-term bonds and hoping that rates and inflation do not rise.

Our approach is well-suited to a challenging quarter like this last one, where traditional bonds took a big hit. The below chart illustrates the performance of all of Morton’s fixed income strategies for the quarter.

The funds grouped together in green typically target shorter-term, more stable bonds, while the blue grouping represents funds that we consider more opportunistic in nature. As designed, all of our strategies significantly outperformed the index (orange bar on graph) in a period of rising interest rates. Beyond the liquid space, we have also made significant allocations to private lending funds that we feel offer a compelling risk/return profile. When appropriate, we prefer to take on some liquidity risk as a substitute for traditional market risk as we feel this effectively accomplishes our goals of risk management, true diversification, and higher cash flow.

You Cannot Control the Wind, but You Can Adjust Your Sails.

This sailing proverb speaks to the current environment and the importance of recognizing both what we can and cannot control. Specifically, the winds of the market and the winds of the economy are circling around in lots of different directions. They are very unpredictable and in many ways are behaving differently from what historical data or norms would predict they should. In this unpredictable environment, it is more important than ever for us to adjust our sails—to manage risk and maintain our calm and resiliency even when the world around us is behaving erratically.

We can adjust our sails by avoiding traditional interest rate risk in our bond portfolios and limiting stock exposure in an environment where prices are being driven by speculation and hope for future growth. There are valid reasons to own stocks, as they could be beneficiaries in certain high-inflation environments, but there are also meaningful risks to stocks, and our focus is on finding investments that fit in with our philosophy and where we can analyze the fundamentals and control a larger number of variables. Integrating alternative assets that align with this philosophy is what we believe builds resilient portfolios for the long term.

Best Regards,

Morton Investment Team


Information presented is for educational purposes only and is not intended as an offer or solicitation with respect to the purchase of any security or asset class. This presentation should not be relied on for investment recommendations. The private investment opportunities discussed herein are speculative and involve a high degree of risk. References to specific investments are for illustrative purposes only and should not be interpreted as recommendations to purchase or sell such securities.

Targets or other forecasts contained herein are based upon subjective estimates and assumptions about circumstances and events that may not yet have taken place and may never take place. If any of the assumptions used do not prove to be true, results may vary substantially from the target return. Targets are objectives, are shown for information purposes and should not be construed as providing any assurance as to the results that may be realized in the future from investments. Many factors affect performance including changes in market conditions and interest rates and changes in response to other economic, political, or financial developments. There is no guarantee that the investment objective will be achieved, and MC makes no representations as to the actual composition or performance of any security.

Although the information contained in this report is from sources deemed to be reliable, MC makes no representation as to the adequacy, accuracy or completeness of such information and it has accepted the information without further verification. No warranty is given as to the accuracy or completeness of such information.

Past performance is no guarantee of future results. All investments involve risk including the loss of principal.

Performance figures reflect the reinvestment of dividends and are net of fund fees, but do not reflect the deduction of MC investment advisory fees. Your returns may be reduced by the advisory fees incurred in the management of your account. For example, the deduction of a 1% advisory fee over a 10-year period would reduce a 10% gross return to an 8.9% net return. Performance for the period reflected is due to a variety of factors, including changes in market conditions and rising interest rates.