Post-election volatility highlights the importance of diversification

Bernard Scozzafava, Diversified Fixed Income Portfolio Manager

Boston - It remains to be seen whether the rally in U.S. equities and dramatic sell-off in Treasury bonds is an overreaction to the surprise victory of President-elect Donald Trump that could fizzle in 2017. However, one thing is certain: Overreacting to market overreactions can cost long-term investors dearly.

Investors have been on an interesting ride the past few weeks. Stocks and bonds have had polar opposite reactions to the U.S. election outcome, which is a reversal of the trend through much of 2016.

The decline in government bonds around the world is the biggest post-election story. For example, the Bloomberg Barclays Global Aggregate Total Return Index fell 4% in November, the largest one-month decline since its 1990 inception, resulting in losses of $1.7 trillion, according to Bloomberg. In the U.S., the Bloomberg Barclays US Aggregate Bond Index is down 2.4% since the election (November 7 to December 5), while the S&P; 500 has increased 3.4%.

Yet, this negative correlation is actually what you want if you're a long-term investor using diversification in stocks and bonds for a potentially smoother ride. When one zigs, you want the other to zag - that's the essence of diversification.

The negative correlation between U.S. stocks and bonds has reasserted itself recently after they both rose during the first three quarters of 2016. Indeed, the Bloomberg Barclays US Aggregate Bond Index was up 5.8% year-to-date through September 30, while the S&P; 500 was up 7.8%. With U.S. stocks and investment-grade bonds both producing attractive returns, there were concerns heading into the fourth quarter that if one traded lower, the other would follow. But that has certainly not been the case after the election.

Even though bond prices have been thumped by rising yields, it's important not to give up on bonds. Aside from income, they can provide diversification benefits as a counterbalance to stocks during flight-to-quality markets. And rest assured, there will be more flights to safety, such as the 5.1% slide in the S&P; 500 in January 2016.

Also, it could be a mistake to assume the recent spike in bond yields will continue at this pace. In terms of a percentage moves, the post-election rise in U.S. 10-year Treasury yields has only happened three other times since 1962. This is an historic move in Treasury yields that probably shouldn't be extrapolated out into the future. In fact, it wouldn't be surprising for yields to pause or even retrace a bit. Also, with about $8 trillion of global bonds still trading with negative yields, U.S. Treasurys are relatively attractive, and foreign demand may keep a lid on yields.

Finally, it could be a mistake to assume the recent outperformance of U.S. stocks will continue. The range of outcomes for the stock market in 2017 seems to be wide based on the uncertainty around Donald Trump's policies such as tax cuts and infrastructure spending.

Bottom line: U.S. stocks and bonds had been moving in lockstep throughout much of 2016. However, their divergence since the election should be a welcome development for investors who use a combination of stocks and bonds to diversify their portfolios.

Diversification does not ensure a profit or eliminate the risk of losses.

Equity performance is sensitive to stock market volatility. An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest.