Fixed Income Investment Outlook: 2014 is Over. Long Live 2014!
2014 is Over. Long Live 2014!
Fixed Income Investment Outlook
Despite healthy skepticism following a spectacular 2013, U.S. equities continued their winning ways in 2014. Usually equities do well when expectations of earnings growth are positive. In 2014, however, we had some divergent market action, which may be indicating exactly the opposite. First, unlike 2013 when interest rates generally rose along with better economic reports and rising expectations for the Federal Reserve (the “Fed”) to raise interest rates, yields on the longer end actually declined in 2014, helping to reverse the Treasury bond losses of the prior year. Declining yields are usually a sign of impending economic weakness. Second, high yield bonds, which are typically positively correlated to equity movements given their sensitivity to the health of the economy, underperformed investment grade bonds in 2014. This was exacerbated by weakness in energy prices at year-end, also normally a sign of expected weakness in the economy. What are we to make of these diverging trends between Treasury yields, high yield bonds and energy prices, whose market action this past year would typically precede flagging economic vigor, and strong equity performance? Will lower energy prices be a boon to our consumer-led economy in the form of higher disposable income or is it a pre-cursor to lower overall demand and a weaker economy? While it is impossible to say for certain, we think the domestic economy continues to heal at a slower pace than most would like. The imbalances that have built up over the past few years are quickly being addressed by market forces, thus laying the foundation for continued progress in this deleveraging cycle, which we have noted before, appears to have a much longer half-life than most historical post-war interest rate cycles. Given these seemingly divergent trends, how do we think about positioning for 2015 and beyond?
Over the past year, the cottage industry that forecasts interest rates and watches the Fed has been operating at full tilt. The Fed is transitioning its forward guidance (read: language) in an eerily similar fashion to a decade ago as it weighs raising interest rates. We’re not sure whether they have a game plan to do so already, or if they are still playing it by ear. Parsing language in the Fed communications to gain incremental insight into future actions can sometimes resemble the Theater of the Absurd. The most recent kerfuffle surrounds the true intent behind the Fed’s substitution of the word “patience” for the previously used phrase “considerable time.” In its most recent communique, the Fed stated that “it can be patient in beginning to normalize the stance of monetary policy.” They added that this is “consistent with its previous statement…to maintain the 0 to ¼ percent target range…for a considerable time…” In essence, they’re telling us that they mean the same thing, which we interpret as: they will raise interest rates when they are good and ready and they are not in a rush to do so, but realize that market expectations can be powerful forces when left unchecked by stale language and free money.
A bit of history here may be useful. Benn Steil and Dinah Walker recently provided some historical perspective in the Council on Foreign Relations blog:
“…at the January 2004 meeting, the Greenspan Fed…had been operating…under a pledge not to raise rates for a “considerable period.” And what did the … Fed do? It dropped its “considerable period” pledge, saying instead that “the committee believes that it can be patient in removing its policy accommodation.”
Many may not remember, but six months later, on June 30th of that year, the Fed raised the fed funds rate. They say that history does not repeat, but it rhymes, so maybe at some point the currently “patient” Fed may soon raise rates as well. In the press conference following the release of the most recent Fed statement, Chairperson Yellen put a finer point on what patience implies; specifically, that “…we think it unlikely that it will be appropriate–that we will see conditions for at least the next couple of meetings that will make it appropriate–for us to decide to begin normalization.” The Fed has meetings scheduled for January, March, April, June and July. Fed watchers will likely be all atwitter for the next six months!
As the Fed considers any future actions, it must assess how it will achieve its dual objectives. The employment mandate seems to be improving, so that leaves the second mandate, that of maintaining stable prices. This was made a bit more nuanced given the recent collapse in the price of oil and some basic commodities. Oil prices peaked in June and have fallen over 50% since. Much of this decline followed the Organization of the Petroleum Exporting Countries’ (OPEC’s) decision not to cut output at their November 25th meeting. The question remains: is the fall in oil prices due to excess supply or insufficient demand? If it’s the latter, then raising interest rates doesn’t make much sense. We believe it is a bit of both and that the price slide will reverse in time. The several factors at work here are first, China, the largest incremental user of oil, is seeing lower demand from both a weaker economy and also their continued deliberate transition to a service-based economy, which uses much less energy than the investment-based economy of the past twenty years. Although China may grow at a slower pace, its energy needs are likely to keep growing long-term, just at a slower rate. Second, U.S. supply has boomed over the past few years from our massive investments in shale-oil and gas producing regions. This has occurred at a time when energy-saving measures, instituted when prices were high, such as solar and wind, hybrid cars, smart houses etc., have dampened growth in demand. Once again, domestic energy use will likely grow longer-term, but possibly at a slower pace. Third, lower gasoline and heating costs should have a positive impact on consumer disposable income, assisted by a strengthening dollar which makes imports cheaper for us. Since we have a predominantly consumer-based economy, this should be a positive catalyst for future growth, and, paradoxically, energy consumption. Oil exporting countries, on the other hand, will undoubtedly go through a rough patch until some equilibrium returns to commodity prices.
Make no mistake, if oil prices remain low for long, U.S. producers are very unlikely to risk damaging themselves to the point of economic and financial ruin; as in the past we may see high-cost exploration curtailed as exploration companies wait for higher prices. Also, the new basins in the U.S. which are mostly responsible for our increased energy independence have very steep production decline curves. This means that supply from wells already drilled will decrease over the next few years and, barring new drilling, should result in lower supplies which would help get us back to a more normal supply-demand balance. In sum, if low oil prices result in greater consumer spending and continued economic growth, then this should not change the Fed’s trajectory and timing on rates (whatever that may be).
Investors seem unsure of the direction interest rates and economic growth will take. The expression “flows follow performance” came to mind in early 2014 as we saw mutual fund investors dumping their core investment grade, interest-rate sensitive funds following poor returns in 2013. Many of these investors moved into more economically-sensitive equity and credit funds, which had better performance in 2013. Specifically, the Bank of America Merrill Lynch U.S. Corporate & Government Index (Investment Grade Index) was down 2.7% in 2013 vs. a gain of 7.4% for the Bank of America Merrill Lynch U.S. Cash Pay High Yield Index (High Yield Index). That is quite a large delta. In contrast, for 2014, the Investment Grade Index gained 6.5% vs. the High Yield Index’s performance of 2.4%. This has caused investors to reverse course, back into investment grade funds while exiting high yield funds. These outflows may be exacerbating the recent weakness in high yield-oriented funds, which were already hit due to energy-related price declines. In our opinion, this is creating some interesting opportunities in the high yield market.
A closer look at some of the inner dynamics of this divergent relative performance may be warranted. Recent positive performance in the investment grade market has been driven primarily by longer-term bonds as the 10-year Treasury yield has declined from 3.0% at year-end 2013 to 2.2% at the close of 2014. Offsetting this has been weakness in shorter-term bonds; rates on sub five-year notes have mostly risen, causing a flattening of the yield curve, while the five-year yield has remained virtually unchanged this year, acting like a fulcrum. In 2004 and 2005, when rates were being raised by the Fed, the fulcrum in the curve was the 7-year note. This meant that the curve flattened (yields rose, prices fell) for tenors below 7-years. After the Fed raised rates about 200 basis points the entire yield curve shifted up and bonds with maturities near the fulcrum or longer lost money, as their prices declined much more than shorter-term bonds. Could the current rise in shorter-term Treasuries indicate that the Fed is nearer to raising the fed funds rate? Time will tell.
The high yield segment of the fixed income market has historically been prone to over-investment booms, like telecom in 2000 and real estate and finance in 2007. Since 2008, we have not seen any new such structural excesses with the exception of the huge capital investment made by energy companies involved in fracking. Given the relatively large weighting of energy in the high yield market, oil’s recent collapse has hurt overall market performance. Specifically, energy (excluding coal) comprised about 14% of the high yield market at year-end 2013 and 15% on June 23, 2014 near the peak in oil prices. From that peak the high yield energy sector fell almost 13% by year-end. For calendar year 2014, it ended down 7.4%. In other words, since the peak in oil prices, the decline in the energy sector alone has lopped nearly 2% from the high yield market’s overall returns, which were up approximately 2.4% for the full year. While we have had a lower weighting in the exploration/production and service sectors of the energy market, we do have small positions in mid-stream companies that are involved in the transportation and storage of oil and gas. We do not expect these issuers to be harmed fundamentally, since oil and gas coming out of the ground still needs to be moved and stored before its sale and eventual use. To the extent that there are shorter-term bonds now sporting higher yields in good non-energy companies to be found among the collateral wreckage, they may be compelling opportunities. We believe that in 2015 the over-investment in energy and the damage it has caused will begin to heal, hopefully leading to a more normal environment.
As we look ahead, we are focused on identifying and understanding areas of potential risk and balancing those with areas of opportunity. We have always believed that over time the best returns are achieved by waiting for “fat pitches” (as we like to call them), and attempting to take advantage of these opportunities when potential future rewards are greatest. Typically these occur following a negative market event, during a recession or crisis following the reversal of an investment excess. Examples are pretty easy to spot in retrospect, such as the Savings & Loan crisis, the internet bubble, the sub-prime mortgage meltdown and the recent energy price collapse. Recognizing such events in real-time, however, is extremely difficult. Most historical crises have been excellent entry points for economically correlated assets such as high yield debt and equities, because the damage was mostly done and the discounting of the recovery still lay ahead; and yields were generally high enough to warrant waiting for that recovery. Often, during these dislocations, bonds of good companies that were not fundamentally impacted by the proximate cause of the selloff, get tarred with the same brush. We strive to be cautious and patient between these great buying opportunities so that we can put cash to work when future returns could become more attractive.
We have tried to never look in the rear view mirror when making investment decisions; the past cannot be changed. One can, however, assess present conditions and make informed judgments about where future macro risks are likely to be and where one feels most confident about the opportunities at hand. Because we chose not to shift into investment grade last year, we did give up some near term performance. However, we believe that at current yields there is no investment grade “fat pitch” at this time. Our focus remains on keeping duration short and layering-in higher yielding paper, especially on sharp corrections in markets like we have seen recently. We believe that the appropriate time to take a swing at investment grade bonds will be when yields are much higher and the economy is teetering towards recession.
We thank you for your continued confidence in our management.
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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The Bank of America Merrill Lynch U.S. Corporate & Government Index (Investment Grade Index) tracks the performance of U.S. dollar denominated investment grade debt publicly issued in the U.S. domestic market, including U.S. Treasury, U.S. agency, foreign government, supranational and corporate securities.
Bank of America Merrill Lynch U.S. Cash Pay High Yield Index (High Yield Index) tracks the performance of U.S. dollar denominated below investment grade corporate debt, currently in a coupon paying period, that is publicly issued in the U.S. domestic market.
Basis point is a unit that is equal to 1/100th of 1%.
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.
Earnings growth is not representative of the fund’s future performance.
One cannot invest directly in an index. 
© Osterweis Investment Management
© Osterweis Capital Management