Quarterly Market Update
Fixed Income Outlook
Foreign Buying Suppressing U.S. Interest Rates
Even though domestic GDP is expected to accelerate and eventually push U.S. yields higher, foreign purchases of U.S. debt are acting to suppress domestic rates. High interest rates in the U.S. compared to over- seas, combined with the strengthening dollar, make U.S. bonds very attractive to foreign investors.
September was an action packed month for the bond market. The yield on the 10-year Treasury climbed 16 basis points, its largest monthly move of the year, but when the curtain came down on the quarter, events had barely moved the needle. The yield on the 10-year U.S. Treasury stood at 2.49%, only 8 basis points from where it began on July 1.
Early in September, concerns about the strengthening U.S. recovery pushed the yield on the 10-year Treasury to a two- month high. By mid-month, violence in the Ukraine and the Middle East triggered a flight to safety, pushing yields back down. On September 26, Bill Gross’s abrupt departure from the company that he founded, Pacific Investment Management Company, was announced. Bond prices temporarily tumbled as sellers rushed to exit sectors where Mr. Gross and PIMCO held huge positions, including Treasuries, Treasury-inflation protected securities (TIPs), and high yield bonds. However, valuations normalized somewhat by month end after the dust had settled. Nevertheless, the bond market’s reaction to Gross’ departure reminded investors that relative calm can quickly evaporate when liquidity suddenly disappears.
Fed Watching Continues
The bond market continued to view events through the lens of the pending conclusion of the Fed’s asset purchase program on October 29, and the anticipation of the first Fed tightening, projected for mid-2015. During the Fed’s August retreat in Jackson Hole, Wyoming, Chairman Janet Yellen shifted away from offering solid forward guidance regarding the timing of future fed funds rate increases, giving the Fed some leeway. However, this latitude introduced a note of uncertainty in the bond market. In statements made after the close of this reporting period, Chairman Yellen backtracked, clarifying that the tightening schedule would be data-dependent, rather than time-dependent.
Sluggish Growth Turns Eurozone Debt Yields negative
It became increasingly apparent as the quarter progressed that the economies of the 18-member Eurozone had begun to stall. With GDP growth slowing and inflation at its lowest level since October 2009, the ECB was forced to provide additional monetary stimulus. Yields on two-year notes issued by some of the 18-member Eurozone members (e.g. Germany, the Netherlands, Austria, Finland, Belgium and France) fell below zero after the ECB began charging Eurozone banks for keeping deposits at the ECB in hopes it would encourage lending. Germany’s 10-year government bond was yielding 0.95% at quarter-end, compared to 2.49% on the 10-year U.S. Treasury. The spread drove foreign buying into dollar-denominated U.S. Treasury securities, helping to perhaps suppress U.S. yields, despite expectations for stronger domestic GDP growth.
U.S. Dollar Hits Multi-Year High
The divergence of monetary policy and GDP growth rates in global economies became more pronounced in the third quarter, helping the U.S. dollar to reach its strongest level in over four years.
Figure 1. The Euro fell against the U.S. dollar during third quarter as the Eurozone recovery continued to flag. The dollar has rallied against the euro and other currencies in recent months, amid expectations that the Fed is growing closer to raising interest rates. Additional downward pressure was placed on the exchange rate in September when the U.S. unemployment rate fell to a six-year low at 5.9%.
The fact that the Bank of Japan and the ECB are continuing to ease monetary policy at a time when the Fed is on the cusp of tightening helped lift the U.S. Dollar Index to a 7.7% gain over the euro, a 7.5% gain over the yen, while also gaining strength against other currencies for the quarter.
Corporate Bond Spreads Widen
Corporate bond returns, as measured by the Merrill Lynch Bank of America US Corporate A-AAA, 1-10 Year Index, were down 0.06% for the quarter, although the index managed to retain a positive year-to-date return of 3.10%. Near historical 10-year lows, with no place left to go but up, corporate bond spreads widened by 10-15 basis points, to 110 basis points over similar maturity U.S. Treasuries in the finance sector and 75 basis points in the industrial sector. As described below, a few landmines arose in September, introducing a degree of volatility with which the market has not had to contend in some time. Investors have gotten quite comfortable reaching for yield, but recent volatility tempered some of that aggression.
Online retailer eBay, Inc. announced plans to spin off subsidiary PayPal due to increased competition from smart phones to pay for purchases, and the A-rated company subsequently experienced about 35 basis points in spread widening caused by deterioration in the price of its bonds. Similarly, Hewlett Packard’s announcement that the company will split into two parts left investors wondering how the debt would be impacted, and spreads on HP’s bonds widened as a result. Earlier in the quarter, rumors of AT&T joining Vodafone briefly led to widening spreads, although that widening reversed after the rumor dissipated.
Investment grade corporate bond issuance is on pace to exceed last year’s record pace. Coming off a backlog built up over the light summer months, September was the heaviest month year-to-date for corporate bond issuance, and the second highest for high-yield bond issuance. In a continued quest for securities paying higher interest rates than government bonds, investors quickly absorbed the record issuance from companies looking to lock in low rates ahead of the anticipated Fed rate increase in 2015.
Supply and Demand Drives Municipal’s Outperformance
Municipals were up for the quarter, partially attributable to simply following the downward drift of U.S. Treasury yields, although light issuance and steady inflows from retail investors also helped. New issuance is down about 6% from the same time period last year, and with investors piling into the market, deals are frequently oversubscribed by four or five times. In the 10-year sector, the difference between AAA- and A-rated bonds tightened from 63 basis points at the beginning of the quarter to 56 basis points at the end, compared to the 12-month average of 71 basis points.
Unlike in the corporate bond market, there were no new notable credit events affecting municipal bonds, and the earlier problems experienced by the city of Detroit and in Puerto Rico appear to have subsided for now. As a result of this reduced credit risk, strong demand, and waning supply, municipal bonds have gotten rather expensive versus taxable bonds.
We remain in the “lower for longer” camp – rates may stay lower, for longer, than investors currently expect.
Our outlook for the bond market has not changed appreciably. Unless employment numbers fall precipitously, the Fed will end its bond-buying program in October and begin tightening at some point in 2015.
Bond investors will earn coupon income from their bonds, but price appreciation will likely be flat for 2014. Certainly, international geopolitical events remain a concern and could conceivably push the yield on the 10-year U.S. Treasury down and prices up. Likewise, continued spread of the Ebola virus could dampen consumption if people choose to stay home in hopes of avoiding the disease. If so, interest rates would stay very low in conjunction with slower GDP growth.
Investors will reassess the Fed’s next steps based on payroll gains, GDP growth, corporate earnings, and more importantly than usual, inflation. Investors have recently begun to interpret low inflation as indicative of weak growth and a reason for the Fed to keep rates lower for longer. The Fed has made it clear that below-target inflation (i.e. below 2%) is a problem it intends to combat using its monetary tools.
What the Fed and the rest of the world wants to see is self-sustaining, organic growth as opposed to inorganic growth artificially created by central bank policies. The best predictor of organic growth is jobs growth. It does not appear that jobs growth in the neighborhood of 250,000 per month is indicative of GDP growth much better than 2 or 2.5%. The economy needs 300,000 or better monthly jobs gains to create expectations that GDP will be rise to around 3%, and inflation to north of 2%. Payroll gains have averaged around 250,000 per month for the year, and now the market wants to see something more impressive.
We remain in the “lower for longer” camp – rates may stay lower, for longer, than investors currently expect. Consensus forecasts for the 10-year Treasury yield have steadily drifted down over the course of the year. Currently, the forecast is for the yield to end 2014 at 2.72% off 23 basis points from earlier forecasts. The continued modest expansion of the U.S. economy is supportive of a 2015 rate increase. However, a combination of factors including a stronger U.S. dollar, aggressive monetary easing policies in Europe and Japan, and a slowdown in China’s growth rate are supportive of lower domestic interest rates for a longer period than was anticipated early in the year.
Figure 2. The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.2 percent in August on a seasonally adjusted basis, according to the U.S. Bureau of Labor Statistics. Over the last 12 months, the all items index increased 1.7 percent before seasonal adjustment.
The dollar’s trajectory will be largely determined by strength in the U.S. economy and the advent of higher interest rates. A strengthening dollar will limit loses by foreign investors in U.S. bonds even if U.S. interest rates rise some. However, investors will be watching to see how the stronger dollar impacts exports of multi-national U.S. companies. A stronger dollar makes U.S. exports more expensive and could lead to declining sales for those companies and widening credit spreads on their debt.
Excluding a major credit event, corporate credit spreads should remain at relatively tight levels for an extended period of time. Once there is a significant rise in interest rates, and investors can substitute higher quality bonds and still meet their income needs, then credit spreads will widen from the bottom up, beginning with financials as higher rates have a more significant impact on that sector.
Municipals will likely remain at their richest level in years, and continue to drift with Treasuries. Favorable technical factors should remain in place although there could be a slight uptick in supply as municipalities look to wrap up their funding and dealers try to push deals through before year end. However, we do not anticipate sufficient issuance to pressure the market because there is plenty of cash on the sidelines in need of a home.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
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International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).