Fixed Income Outlook
Are Rising Rates on the Long-Term Horizon?
Fixed Income Investment Outlook
Following the rally in 2013 for U.S. equities, investors in Q1 ‘14 questioned whether the higher price/earnings multiples and the economy could weather continued tapering from the Federal Reserve (“the Fed”). In fact, it is the weather that has caused most of the consternation so far this year. Winter storms and frigid temperatures across the East, combined with continued drought conditions in the West, have investors worried about the impact on economic growth. Mounting reports of flight cancellations and business closings reinforced fears of a first quarter earnings slowdown. Natural gas prices also spiked as demand swelled due to the cold weather, adding another economic headwind. As a result, there will be distortions to employment and economic data in the first quarter, and we will have to wait until at least the second quarter to find out if the stronger (revised) economic numbers in the fourth quarter will return. We could also see some knock-on effects as China’s growth slows and credit concerns rise. Finally, there are worries about a potential “tapering of the taper” and a return to unbridled risk-taking given the near-term economic softness. We’ll discuss these concerns below.
For the past seven months, Bloomberg’s Economic Surprise Index has dropped from positive to negative readings, meaning that economic releases are now predominantly weaker than expected. In addition, real Gross Domestic Product (GDP) estimates and S&P earnings expectations have been ebbing. For example, Q1 GDP forecasts, which had been averaging 2.5%, (something the Fed could certainly live with), are now below 2%. Full-year S&P revenue and earnings expectations have also been cut but seem to be bottoming. We continue to keep an eye on revisions and seasonal adjustments, which we discussed in our last Outlook.
All is not glum. Employment statistics have continued their improvement, most importantly in the broader measure, U-6. (The more widely reported statistic, U-3, excludes part-time employed, as well as people who would like to work but are not necessarily looking. U-6 is a broader measure of unemployment which adds back these exclusions.) While still historically high, the U-6 measure continues to improve. Additionally, the Purchasing Managers Index has been above 50 (readings above 50 indicate growth) for all of 2013 and so far in 2014. While the Consumer Price Index remains positive, it remains below the Fed’s desired target of 2%.
China was exporting deflation to developed economies, while exporting growth to resource-rich economies such as Brazil, Africa and Australia. Now that China’s construction/investment-led growth is yielding diminishing returns, their attempted pivot to a more consumption-based economy is putting a damper on growth. Estimates are that a consumption-led economy generates only about a quarter of the jobs that an investment-led economy does; therefore, a significant slowdown in China’s GDP growth seems inevitable and could be felt globally. The excessive lending and unchecked debt growth at both official and non-official (“shadow banking”) lending institutions during the past decade is now stressing their financial system. In order to raise capital for lending and construction, Chinese banks and investment firms issued to consumers high interest rate trust/investment products that were backed by loans to companies across a wide array of industries. Many of these products were guaranteed by volatile commodities and low quality companies that were very economically sensitive. As a result of the slowdown, we are now seeing some of these vehicles struggle to pay investors as these investments mature. One was recently bailed out by the Chinese government, and another has defaulted. There appears to be a few more in negotiations with investors as to how much money they can expect to receive. So far these defaults have had a small impact but they may serve as the proverbial “canary in the coal mine” for what may yet come. Chinese banks have significant exposure to this potentially toxic debt, and it could have a real negative impact on Chinese growth. Stay tuned.
Looking at the U.S., in March, Janet Yellen presided over her first Federal Open Market Committee meeting as Chairman of the Fed. The committee further reduced its bond buying, citing sustained economic growth. As is usually the case, the public question and answer session with reporters was where the real fun began. Chairman Yellen noted that the 6.5% unemployment target would no longer be used as a signpost to begin raising the fed funds rate and indicated that the committee was now tracking a list of other economic statistics. Then, while trying to rehash the point that no pre-set future path has been decided, she focused reporters on the “dot plot” of forecasts by Fed officials of future fed fund levels. These clearly show higher rate expectations for 2015 and 2016 and, unlike the plots we discussed in our previous Outlook, they are not as divergent now but have a decidedly more upward bias. Not wanting to leave it to the off-chance that someone might miss the hawkishness of the statement, she then proceeded to explain that rate hikes, post tapering, could come as soon as six months after the end of tapering. Some commentators felt she had made a mistake and omitted the words “at least,” but when we look at other clues, they confirm that she likely meant what she said. Fed Governor Jeremy Stein, who alerted people a year ago to the possibility that there were bubble-like elements in the high yield market and in agency mortgage REITS, was in fact laying the groundwork for the surprise taper announcement last May. In a March 21st speech this year (thank you David Zervos for pointing this out), Governor Stein said:
“I am going to try to make the case that, all else being equal, monetary policy should be less accommodative—by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level when estimates of risk premiums in the bond market are abnormally low. These risk premiums include the term premium on Treasury securities, as well as the expected returns to investors from bearing the credit risk on, for example, corporate bonds and asset-backed securities.”
Paraphrasing David Zervos, he thinks Mr. Stein is saying that the Fed should try to tamp the excesses in credit markets by withdrawing stimulus (read “raise rates”) when those markets get frothy. Keep in mind that this is from a Fed that has never peremptorily acted to prick an asset bubble in its 100-year history. Despite this inconvenient fact, not to mention their less- than-prescient forecasting record, we should still be aware that if they do raise rates sooner than investors expect, bond prices could decline sharply, akin to a recoil from a too tightly wound spring.
Given that the Fed is likely to complete its asset purchases this year and may raise rates in early 2015, we still feel that Treasuries and investment grade bonds are unattractive. Although yields in the high yield universe are low by historical standards, they still give us a decent cushion against rising rates, especially at the shorter end of the maturity spectrum. In addition, the slowdown in China and the end of the commodity cycle may act as a tailwind to growth here in the U.S., somewhat muting credit risk. Additionally, select convertible bonds may also be attractive. We believe that maintaining a shorter duration exposure in high yield and some convertible bonds, as well as a cash reserve, continues to make sense. Having this cash reserve should provide us with the flexibility to buy attractively priced securities during selloffs and also may dampen the effects of market weakness.
We thank you for your support.
Carl Kaufman Simon LeeBradley Kane
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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Shadow banking refers to unregulated financial intermediaries involved in facilitating the creation of credit.
Price/Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted EPS.
Duration measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.
Bloomberg’s Economic Surprise Index measures the actual outcome of economic data releases relative to consensus estimates.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
One cannot invest directly in an index. 
© Osterweis Capital Management
© Osterweis Capital Management