Midyear fixed income: Pressure points, catalysts, and credit cycles
June 22, 2012
Fixed income strategist Paul Matlack shares his midyear views on several risks and opportunities that he believes are likely to shape financial markets in the coming months. He discusses developments in the U.S. and abroad, shedding light on the types of bonds that he thinks could perform notably well.
On the global economy: Downside risks outweigh growth prospects
Our fixed income team generally expects global economic output to remain well below its full potential, as still-robust growth in the Asian region is offset by recessionary conditions in Europe, subdued growth in the United States, and slowing growth in several of the larger emerging market economies.
In our view, there are more downside risks at present than catalysts for growth. In particular, the potential for slower-than-expected growth in both the U.S. and China, and a disruptive worsening of the European situation, could affect output and consumer and business sentiment on a global basis.
On U.S. economic growth, risks, and opportunities: Continued pressure on spending and consumption
We expect U.S. economic growth to trend at a subdued rate of 2% in 2012, in our opinion, due largely to the following reasons:
Substantial labor market slack (including both cyclical and structural unemployment and underemployment) and modest wage growth imply muted consumer spending growth.
Excessive debt at both the federal and state levels could very likely freeze or reduce aggregate government spending.
Economic, tax, and political uncertainty could limit the growth of corporate investment spending.
Export growth will likely remain a bright spot due to the weak dollar, but as a percentage of gross domestic product (GDP), exports are probably too small to overcome the drag created by the components mentioned above.
The chart below shows elevated unemployment levels over the past several years, taking into account the underemployed.
A grim unemployment picture
This chart depicts the U-6 unemployment rate. U-6 refers to those unemployed and looking for work, part-time workers looking for full-time work (the underemployed), and discouraged workers who have dropped out of the labor force.
Data: U.S. Department of Labor, June 2012
In addition, bank lending, while expanding, remains substantially muted relative to comparable periods of past expansions. Lending is uneven across industrial and consumer sectors, and in combination with reduced home equity, it is limiting the amount of capital available for the formation of small businesses. A high percentage of homeowners is finding itself in a so-called “underwater” predicament, creating another limit to normal labor mobility patterns and adding a further drag to employment growth.
Brief notes on the more explicit risks and opportunities we see in the coming months:
Risks: Severe recession within the euro region (and we’re not ruling out a breakup of the union as a worst-case scenario) could affect U.S. economic growth and capital markets, heightening consumer and corporate uncertainty, and depressing spending and investment. Failure to address U.S. fiscal problems also could have long-term consequences for interest rates and growth; all solutions will likely involve higher taxes and lower government spending, which should dampen growth.
Opportunities: Bank lending is slowly beginning to show signs of becoming less restrictive (see the chart below), and home prices are stabilizing in many regions, while energy prices are declining. In addition, energy production trends offer the potential for self-sufficiency within 15 years, with positive implications for U.S. growth and fiscal repair.
Total value of commercial and industrial loans: All banks in the U.S. (in billions)
Data: Board of Governors of the U.S. Federal Reserve, June 2012
On the current state of credit markets: Continuing to bear down on the global economy
Credit markets are largely repaired since 2008, although bank lending and securitization remain muted relative to pre-crisis levels. Bank balance-sheet repair (in the U.S.) is largely complete, and higher regulatory capital ratios together with tighter financial regulation imply that the next credit downturn should be less severe and less disruptive to the economy as a whole.
Loss of major market makers — the likes of Lehman Brothers, Bear Stearns, and Merrill Lynch — as well as generally reduced trading capital and heightened risk aversion on the part of remaining major underwriters, imply a higher embedded liquidity premium in bond risk spreads going forward, and heightened volatility in bond markets relative to pre-2008 levels. In addition, broader interconnections between national financial markets and institutions, greater global capital flows, and the rapid growth of derivatives relative to cash markets increase the speed with which national events impact global markets.
On a global basis, large, well-capitalized corporations have pre-crisis levels of access to bank and debt markets. During the next several years, barring a disruptive conclusion to the European monetary crisis, we believe credit markets can be expected to return to full stability and depth, with positive growth implications for the U.S. and global economies.
On the European Union: Tough answers for tough questions
The European crisis seems to us an outgrowth of forming a monetary union without an accompanying fiscal union. With too much fiscal autonomy at the national level, inadequate centralized oversight, broadly different national economic identities, and different goals between the northern and southern tier countries, fissures that were largely under the surface finally emerged under the stress of the 2008 credit crisis.
Greece, Portugal, Spain, and Italy share (to various degrees) the same common problems: excessive government spending that has led to unsustainable levels of debt; high unemployment and unaffordable public sector wage and benefit structures; inefficient, unbalanced, and overregulated economies; and an undercapitalized banking sector burdened with loan losses associated with inadequate risk management and overly aggressive lending.
The most likely outcome, in our opinion, remains a protracted, but ultimately successful, package of concurrent measures aimed at addressing the issues listed above. At the national level, countries will need to pursue fiscal austerity and a broad package of legislation aimed at decreasing regulation and improving national competitiveness. At the regional level, much tighter fiscal coordination will be necessary, albeit at the expense of some degree of sovereignty.
In addition, the range of European Central Bank (ECB) funding mechanisms established during the last several years will need to be sustained and increased in order to provide breathing room for fiscal reforms to gain traction. The process will be measured in years, not months, in our opinion, and should certainly be accompanied by economic contraction as government spending and bank lending declines. This process will likely be uneven and could contribute to heightened equity and bond market volatility until true progress is achieved.
On U.S. inflation: Outlook remains subdued
We do not expect inflation to rise much above a nominal 2% level for the foreseeable future. The significant resource slack in the U.S. economy (both labor and productive capacity), coupled with a growth rate that is at a near stall, suggests that it will be very difficult for inflation to become structurally embedded in the economy. In addition, there is no expectation of inflation on the part of consumers, which is essential for inflationary pressures to take root. Furthermore, from a monetary perspective, the record-breaking liquidity injected into the banking system by the Federal Reserve has largely remained trapped within bank reserves, and has failed to enter the broader economy via lending (which remains subdued, as noted earlier).
The weaker dollar, combined with heightened geopolitical event risk (particularly from the Middle East), implies the potential for spikes in energy prices that could affect consumer spending. However, energy prices constitute a small portion of the final cost of goods and services, and given the low growth rate prevailing today, we see little likelihood that hikes in oil prices will ignite a broader inflation problem.
On bond markets today: Diversification may offer a favorable risk-return trade-off
Given the record low level of risk-free (U.S. Treasury) interest rates, and the relatively tight yield spreads between major bond market sectors and Treasurys, we expect prospective bond returns regardless of sector to consist largely of income. Further, Treasury yields are increasingly range bound, implying that the next major move in interest rates will be up, although we do not expect this to occur for some time given the anemic rate of growth in the U.S., high resource slack, and low inflation prevailing currently.
To use a baseball analogy, we view the bond market as offering “singles” currently, as opposed to doubles or triples (with the one exception of high yield bonds), and thus view a broadly diversified approach to the market as offering a notably favorable risk-return trade-off currently. In particular, we favor U.S. investment grade and high yield corporate debt, higher-quality mortgage-backed securities, commercial mortgage-backed securities, and higher-quality emerging markets and sovereign sector exposure. In addition, manager latitude to make tactical shifts should become a significant source of relative return as there are few truly cheap sectors remaining. Furthermore, because interest rate moves cannot be predicted with precision, we currently favor an intermediate duration bias.
On corporate credit: Our team's best investment idea in the current environment
We currently have a notably positive view of U.S. corporate credit, particularly high yield bonds. In our view, U.S. corporations — those rated investment grade as well as those rated below investment grade (high yield) — are exhibiting some of the best credit metrics in a generation. A combination of factors has resulted in record-high credit quality and record-low default rates. These factors include:
cost-cutting efforts undertaken in response to the credit crisis
a refinancing wave at interest rates not seen in 60 years
record-high cash balances as a result of subdued investment spending (as discussed above)
(For a look at how default rates have behaved over time, see the chart below.)
Default rates for high yield debt are at record lows
Data: NYU Salomon Center for the Study of Financial Institutions, June 2012
With credit spreads in excess of 7 percentage points over Treasurys and an absolute yield of nearly 8%, we believe high yield bonds offer the highest value and return potential in the bond market today. The long-term average high yield spread above Treasurys is approximately 5.5 percentage points, while at cycle peaks (such as those seen between 1996-1997 and 2006-2007) spreads typically narrow to 2.8 percentage points. (Yield data: BofA Merrill Lynch.)
For a closer look at how this relationship has played out, see the chart below.
Higher yield bonds: Spreads remain wide versus Treasurys
Data: BofA Merrill Lynch, June 2012
Credit spreads thus remain wide by any comparison, particularly in light of underlying credit metrics. What’s more, high yield bonds have historically been the strongest fixed income performers when interest rates rise in association with a growing economy, as the underlying companies are generally improving in quality and the excess spread is available to absorb higher rates.
The views expressed represent the Manager's assessment of the market environment as of June 2012, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's current views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The Fund may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for the Fund to obtain precise valuations of the high yield securities in its portfolio.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
International fixed income investments are subject to currency risk. Adverse changes in foreign currency exchange rates may reduce or eliminate any gains provided by investments that are denominated in foreign currencies and may increase losses.
If and when the Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, the Fund will be subject to special risks, including counterparty risk.
Diversification may not protect against market risk.