Can you believe that the year is almost half over? Time flies when you are having fun. Further proof that time flies (and wait’s for no man) is that it will be five years ago next month that the so-called “Great Recession” officially (and statistically) ended. The economic data observed during the past five years were such that the recovery did not feel like a recovery. Recent surveys indicate that the majority of Americans believe the economy is still in recession. However, we are seeing rays of sunshine breaking through the clouds. We are optimistic about the economy and although the economy might not be comparable to a bright, sunny and cloudless day as it could have during past (bubble) expansions, comparisons with a warm and partly sunny day appear to be warranted.
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Here Comes the Sun
The National Federation of Independent Business Small Business Optimism Index climbed to 96.6 versus a prior 95.2 and a Street consensus of 95.8. The print of 96.6 was the highest since the 97.7 print in September 2007. However, NFIB chief economist (and fellow Global Interdependence Center member) Bill Dunkelberg said in a statement:
“May’s numbers bring the Index to its’ highest level since September 2007. However, the four components most closely related to GDP and employment growth (job openings, job creation plans, inventory and capital spending plans) collectively fell 1 point in May. So the entire gain in optimism was driven by soft components such as expectations about sales and business conditions. With prices being raised more frequently in response to rising labor and higher energy costs it is clear that small businesses are unwilling to invest in an uncertain future. As long as this is the case the economy will continue to be “bifurcated”, with the small business sector not pulling its historical weight in the GDP numbers.”
It appears as though the economic outlook is becoming brighter, but employment clouds appear to be pointing toward warm, but not hot economic weather.
JOLTs job openings data indicate that (unlike the NFIB survey) hiring conditions look a bit brighter. Job openings in the U.S. climbed to an almost seven-year high in April as employers sought more workers to help meet stronger demand as the economy rebounded following a harsh winter. The number of positions waiting to be filled in the U.S. rose by 289,000 to 4,455,000 in April, the highest since September 2007, according to the labor department. This was up from a prior revised 4,166,000 (up from 4,014,000) and significantly higher than the Street consensus of 4,050,000. However, the pace of firing rose 3.3% versus 3.1% for job openings. Although the JOLTs data were encouraging, we must point out they are backward-looking and reflect conditions during what might prove to be the peak of the post-winter rebound.
A concern of ours is that much of the hiring has been in retailing and in leisure and hospitality, which can be highly seasonal. We do believe that the economy should continue to expand, but just as economic data from last winter did not paint an accurate picture of the U.S. economy, the spring rebound might be overstating the true economic growth potential of the U.S. economy.
Inventory replenishment and expansion has been a major driver of the economy during some of its strongest months and quarters. April Wholesale Inventories data indicated that inventories excluding oil rose 1.1%. Wholesale sales rose 1.3% in April after rising 1.6% the prior month.
Today’s data appear to indicate the economic ice is slowly melting. We expect the economy to expand at a moderate pace for the balance of 2014. However, this might not translate into impressive gains in risk asset valuations.
On the Dark Side
Risk assets have had an impressive run during the past few years. In fact, risk asset performance has been more robust than economic data. A popular selling pitch among wholesalers was that risk assets are attractive because they were performing well and they tend to do well when the economy gains momentum. The reality is; the capital markets tend to get ahead of the economy. When there is a glimmer of a recovery, sophisticated investors tend to act proactively. By the time economic data appears to justify risk asset valuations, the best (if not all) opportunities are in the rearview mirror.
The process was accelerated because of extreme monetary policy accommodation (resulting in very low interest rates) which forced investors into risk assets well before fundamental data justified such valuations. The second wave was that of investors who believed that the Fed would be successful. The third wave of investors into risk assets consisted mainly of those who missed the best opportunities and have finally capitulated and are pouring money into risk assets, often using the idea that risk assets should outperform as the economy improves.
It is our opinion that the best days of risk assets are probably behind us for now. This is evidenced by the fact that higher-quality fixed income investments have performed as well (if not better) than their high-risk brethren. We are not unique in this view (although we have been among the first to suggest moving up in quality and to shorten duration on the long end of bond portfolios). During the past month we have witnessed an increasing number of fixed income market participants and portfolio managers move toward our position.
We have read articles in various publications which featured interviews with fixed income money managers who believe:
• Low foreign sovereign yields could hold down long-dated U.S. Treasury note and bond yields.
• It is time to take on some duration.
• It is time to reduce exposure in junk bonds and banks loans, particularly in the CCC and lower area of the credit spectrum.
If one searches the Wall Street Journal, Barron’s or Bloomberg News, one can find multiple articles speaking to this.
It is our opinion that further price appreciation in junk debt (bonds or loans) could be problematic. Interest income should be the prime drivers of returns among lower-rated fixed income securities. As such, we believe that it is in the best interest of our readers and asset management clients, for whom high yield investments are appropriate, to focus on BB-rated high yield credits. This is not to say that values cannot be had in B-rated bonds, but in this environment, the lower you reach, the more selective you need to be.
Into the Great Wide Libor Spread
For the past five years, we have preferred step-up notes over floating-rating rate securities. The notable exception has been fixed-to-float securities with attractive fixed coupons, a long fixed period and a floating spread over their typical Three-month Libor benchmark of at least 300 basis points. We advised readers to avoid fixed-to-float securities with low fixed coupons and, particularly, those with very narrow floating-rate spreads. Our thinking has been that the Fed might not raise short-term rates for a long-time and, when it does, rate increases could be moderate and gradual. Thus far, this strategy has worked out well. We continue to favor this strategy when building out the long end of a fixed income ladder or barbell.
Our long-time readers (especially those who followed us at Citigroup) should recall that we were calling for a long-period of low Fed Funds Rates and a lower-than normal equilibrium rate as far back as 2010. Not much has changed in our outlook, except that we are probably about a year away from the start of Fed Funds Rate hikes.
Our advice to readers considering floating-rate or fixed-to-float securities is to not be drawn in by the lower prices typically found with securities offering narrow floating spreads. The reason they are trading at lower prices than their wider-spread brethren is because narrow coupon spreads might not offer much interest rate (or asset price) protection in a rising rate environment.
By Thomas Byrne – Director of Fixed Income – Investment ConsultantThomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. Employment
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
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