The purpose of our weekly “In the Trenches” report is to provide insight into what fixed income professionals are seeing on the front lines. This often differs from the 20,000 feet perspective provided by many other market information sources. Front line views of the fixed income markets are often criticized, sometimes mocked, in the financial media, but it has been our experience that when all is said and done, the front line view tends to be correct in the end.
Around the World or Around the Block
During the first half of 2014, long-term interest rates have declined. The yield of the benchmark U.S. 10-year Treasury note began the year at 3.00%. At the time of this writing, the 10-year note’s yield stood at 2.46%. Some media pundits and participants from other areas of the capital markets asked: “What does the bond market see?” Others simply stated that the bond market’s apparent view that the economy was not that strong was “wrong.” Although imperfect, the bond market is rarely far off base in its view of economic growth and inflation conditions. Global economic data from the first half of 2014 indicate that the bond market might not have been so wrong after all.
The operative word here is “Global.” There are no truly domestic economies anymore. Capital, jobs and even workers can migrate from one part of the world to the other more easily than ever before. This means that growth, inflation and sovereign debt yields in one area of the world affect economies around the globe. What the bond market saw was moderate growth in the U.S., poor growth in Europe, fiscal dysfunction in Japan and economic growing pains in China. Please tell us which of these has proved incorrect.
Hazy Shades of Spring
As the second quarter unfolded, bond market participants became increasingly skeptical of the much-anticipated spring
rebound from the harsh winter which battered the economy. As the quarter began and Nonfarm Payrolls data indicated monthly job growth averaging well over 200,000 new jobs per month, some economists, media pundits and equity market participants made bold calls for 4.00% (or higher) economic growth in the second quarter of 2014. Since then, Q2 GDP estimates have been adjusted continuously lower. According to the most recent Bloomberg survey of (78) economists, the consensus estimate for Q2 2014 GDP is 3.25%. We should note that this survey was conducted prior to last Friday’s Durable Goods data which indicated that Capital Spending was lukewarm during the second quarter and business behaved cautiously with regard to inventory building and replenishment. We saw several firms lower their Q2 GDP forecasts to or below 3.00%. If the consensus is even close to correct, it would mean that first-half 2014 U.S. economic growth was essentially flat.
That a spring “rebound” just got us back to flat is troubling because it indicates that it might have been more than weather which was to blame for the -2.9% Q1 GDP. We came to that conclusion three months ago. Some of the downturn appears to be due to a hangover from robust (overly-robust) inventory buildups in the second half of 2013. This is consistent with Bond Squad’s assessment of Q1 U.S. GDP. Although we did not expect 4.00%+ U.S. GDP for Q2 2014, we believed that the rebound would be in the mid-3.00% area. However, it was the surprisingly-weak Q1 GDP of -2.9% (revised down an initial reading of +0.1%) which through us for a loop. It should be noted that the Street’s initial forecast for Q1 GDP was 1.2%. There was more than the weather at work here and the bond market knew it.
According to the Bloomberg survey of economists, the consensus forecast for Q3 GDP stands at 3.10%. The survey indicates the same estimate for Q4. However, we have seen some economists lower their Q3 and Q4 GDP estimates below 3.00%. Pre-holiday inventory building should (hopefully) push Q3 GDP above 3.0%, but Q4 could be challenging. The bond market appears to be pricing in an economy which is fundamentally capable of growing at a 2.5% to 3.5% pace (exogenous and weather shocks not withstanding). Although the weak first-quarter and a more- modest-than-hoped for rebound in Q2 will probably result in 2014 annual GDP averaging below 2.00% (consensus forecast is for 1.7%), 3.0% growth feels about right over the longer- term. It could be that lower rates than usual might be required to generate 3.0% growth.
Word from the Wise
Last week, the Wall Street Journal’s “Market Watch” interviewed former Fed Chairman, Alan Greenspan, regarding asset bubbles and economic conditions. Mr. Greenspan made some notable comments. He stated:
“How to unwind the huge increase in the size of its balance sheet with minimal impact. It is not going to be easy, and it is not obvious exactly how to do it.”
Regarding potential market reaction to Fed tightening, Mr. Greenspan opined:
“Look what happened when the first indication of tapering occurred. Markets have always been sensitive. They reflect animal spirits.”
Regarding the Fed’s comments on asset values, Mr. Greenspan said:
“You can’t get around the fact that asset values have a major impact on economic activity, and no central bank can be oblivious to what is happening, not only in credit markets, which is, of course, the Fed’s fundamental mandate, but in asset markets, as well. As a central banker, in addition to evaluating stock prices, you have to cover commercial-real- estate markets, commodity markets and the price of owner-occupied homes, as well. Without asset-market surveillance, you do not have an integrated view of how the economy works. How to respond to asset-price change is a legitimate issue. But not to monitor it, I think, is clearly a mistake.”
Although Mr. Greenspan believes that central banks should manage asset valuations, he does not believe that they can suppress bubbles, stating:
“I do believe that central banks that believe they can quell bubbles are living in a state of unrealism.”
We are mostly in agreement with Mr. Greenspan. Although his legacy might be tarnished due to policies blamed for the housing bubble (contributing to conditions created by fiscal policies and Wall Street engineering would be more accurate), few question Mr. Greenspan’s financial acumen. It is our opinion that, because central bank policies can influence asset allocation (misallocation and dis-allocation), it not only has a right to comment on market conditions, but a duty to do so. Investors are free to agree or disagree and listen or not listen to the Fed’s market commentary. Market participants have aggressively argued that the stellar performance of most asset classes has been mainly to do improved fundamentals and not Fed policy. If this is true, why do they care so much about what the Fed has to say? Anyone who has significant capital markets experience knows that Fed policy and credit conditions have far-reaching effects. Deny this at your own peril.
Morningstar published an article, last week, which discussed the lack of the much anticipated (not by Bond Squad) “Great Rotation” and the changing landscape of fixed income asset allocation. Morningstar noted investor preference for non-traditional fixed income investments, such as high yield debt. Morningstar states:
“What’s driving these flows isn’t a mystery. With bond yields low, investors have had to look harder to find income. It’s hard to remember, but the yield-to-maturity on the Lehman U.S. Aggregate Bond Index (now Barclays) stood at close to 5% in December 2007; by June 2014, it was a paltry 2.2%.”
We have presented similar data in recent editions of “In the Trenches.” Morningstar’s research indicates that junk bond and bank loan investments lost about 25% in 2008. We featured 2008 and similar 2000 data in the 7/20/14 edition of “In the Trenches.” In this world of technical analysis and referring to past conditions, we find it interesting that few publications and strategists have mentioned the negative aspects of past junk debt asset performance.
We continue to see cracks develop in the junk debt market. How far the cracks will
ultimately extend remains to be seen. However, recent data indicate that a move away from junk debt is well underway. Recent capital flows data indicate that $2.38 billion flowed out of high yield debt ($413 million from loans) last week. This is the largest outflow since the week of 8/21/13, according to Lipper. (1)
Renown high yield debt expert, Martin Fridman, said in a report last week:
“Extreme overvaluation has now persisted for the longest period on record. Overvaluation (whether extreme or non- extreme) has put together an unbroken streak of 25 months, nearly double the previous record. Contrary to the representations of those who hope to keep attracting capital to the asset class, the overvaluation is not isolated in the bottom tier of credits, leaving BBs and Bs as a comparatively safe haven.”
“For the ninth consecutive month, the high-yield market is extremely overvalued, according to our fair-value methodology. This streak breaks the previous record of eight, set in the period from October 2006 to May 2007.”
“There is an ominous ring to the notion that the current extremism is more persistent than in that period. The option-adjusted spread (OAS) on the BofA Merrill Lynch US High Yield Index ended May 2007 at 246 bps, fully 152 bps below the then-prevailing fair-value estimate of 398 bps. Over the next five months, the OAS more than doubled, to 575 bps. The index’s total return over that span was -2.79%.”
Bond Squad remains unconstructive on the junk debt space, but does see pockets of value in BB-rated credits, where suitable for specific investors.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas 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.
- 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
Director of Fixed Income
Wealth Strategies & Management LLC