A key objective of our quarterly strategy meetings is to assess whether developments over the next 3-9 months could lead to a shift in the investment landscape and an associated change in trend in global yields, currencies or the performance of risk assets. Outside of the ever present risks associated with geo-political developments, the key trigger points for a sea change in the environment remain either: (1) A surprising acceleration in global inflation; (2) A monetary policy mistake in the direction of too early and/or aggressive tightening from the US Federal Reserve; Or, (3) the attainment of valuation and investor exposure levels in sectors like US HY that are unsustainable. Although the global outlook is becoming more complicated given policy divergence within the developed markets and a growing divergence between the developed and emerging blocs, we do not believe that the risks associated with either inflation, policy or valuation have risen enough to merit a change in our core views.
Inflation is clearly a global phenomenon and is primarily driven by spare capacity. Although non-accelerating inflation rate of unemployment (NAIRU) estimates in the US continue to be lowered (with the latest move made by the Federal Open Market Committee (FMOC) last week) there has been an unequivocal tightening of the US labor market. Previously, this degree of tightening has been associated with rising wage pressure and the beginnings of a more sustained rise in inflation. However, this process has failed to materialize in the US; not least because spare capacity elsewhere in the world remains considerable. Although faster growth in the Eurozone and potentially Japan will start to erode spare capacity further, the overhang of capacity in the developed world as a whole remains considerable.
Perhaps most importantly, growth in the emerging markets remains weak and weaker than expected. Leading indicators for 3 of the key BRIC economies continue to deteriorate and are consistent with increasing spare capacity and lessening inflation pressure. China is likely to remain a key exporter of disinflation over our investment time horizon. Despite efforts at the margin to loosen conditions, the overall stance of Chinese macroeconomic policy remains tight. While the assumption is that the authorities will prevent a more damaging slowdown in growth, policy-makers do not appear to be overly alarmed by current trends. With the currency being dragged higher by its link to the US dollar, inflationary pressures are continuing to ease and it is likely that Producer Price Index (PPI) inflation slips deeper into negative territory in coming months. This will ensure that overall goods price inflation emanating from the Far East and the emerging markets in general remains muted.
The graph attempts to put in perspective the impact of global growth on the evolution of global spare capacity. The blue line is a simple average of the GDP weighted G10 and overall EM proprietary leading indicators. Because of weakness in EM, the global indicator is only just above trend. The red line then takes the cumulative readings of the global lead indicator to form a proxy for spare capacity. This highlights how limited the unwind of spare capacity has been.
Global Proprietary Leading Economic Indicator and Spare Capacity Proxy
Crucially we still see global monetary policy as supportive for financial market liquidity going forward. The impact of the European Central Banks (ECB) and Bank of Japan’s (BOJ) quantitative easing (QE) programs on the global monetary base is well known, but a key fear in markets has been the potential for the FOMC to initiate a tightening program that offsets this and has a more powerful negative impact on expectations and investor sentiment. If anything these fears seem to be receding. The FOMC has had to respond to the clear lack of wage inflation pressure and a topping out of US growth expectations by realigning its forward guidance on policy. Tightening that would upset risk appetite through renewed concerns over future market liquidity would need to involve a significant uptick in short rate expectations and fears that a process of reducing the Federal Reserve’s balance sheet could be initiated in the not too distant future.
Evidence of excessive investor positioning and valuation in higher-yielding sectors of the fixed income markets would be a concern. But, our anxiety level will remain low until some combination of the following has emerged: (1) Spread levels have moved in much further toward previous cyclical tights; (2) Evidence emerges of significantly increased issuance in response to a more rapid acceleration in expected economic growth; (3) An unexpected tightening in expected monetary conditions. Obviously, we place a low probability on the latter in our baseline scenario. However, we will be monitoring the private-sector bond supply response in coming weeks. A much more positive sign on the economic outlook would be evidence of a significant uptick in corporate bond and ABS issuance in the Eurozone. This would relieve some of the downward pressure on government bond yields and reduce excessive demand pressure on fixed income assets in general. With regard to valuations across the fixed income sectors we do not see them as stretched or an impediment to outperformance over the next 3-9 months. Corporate IG and HY spreads are still attractive and low real borrowing costs for corporate and consumers remain a key part of the healing process. Corporate balance sheets remain solid and default rates low, and there is no evidence of a marked change in corporate behavior with respect to increased leverage.
We will be watching risks as and when they evolve in coming weeks and months, but conviction around our baseline scenario of benign inflation and continued policy accommodation on a global basis remains high.
Cash segmentation is a sensible strategy in any market environment, but it can be especially useful when there’s a steep front end of the credit curve, as we see today. Credit fundamentals remain solid, and we believe when looking at the front end of the yield curve (with maturities of less than two years) one should focus on the 15-month-and- in part of the curve. Here’s why:
Yield on the EDSF is close to its one-year high
Looking at the Euro Dollar Spot Forward (EDSF), a pricing benchmark for credit whose maturities are less than 13 months, we see the current level of the one-year EDSF at an attractive 0.48%. That is well above its one-year average of 0.34% and only a few basis points below its one-year high of 0.53%. The EDSF trades at such a relatively high yield despite the news from the March 18th Federal Open Market Committee (FOMC) meeting, which was an important one for the Federal Reserve. FOMC members significantly lowered their interest rate forecasts in all periods from 2015 to 2017. The median forecast for 2015 now anticipates two rate hikes, whereas prior forecasts called for three or four hikes. At current yields, the break -evens of securities with maturities of 15 months and less vs. traditional cash investments look attractive over the next year across most interest rate scenarios.
If the Fed moves more quickly than projected, then floating rate notes (FRNs) may be quite helpful. FRNs can also serve as a complement to shorter fixed rate purchases in a cash segmentation strategy.
Bank ratings downgrades cheapen credit in the one-year part of the curve
Ratings downgrades in the banking sector by some of the Nationally Recognized Statistical Ratings Organizations (NRSRO) are making credit in the one-year part of the curve attractively valued. The basic premise of these downgrades over the past year has been the removal of an implied government support from each bank’s ratings. Banks generally have stronger balance sheets and better liquidity profiles than they did during the financial crisis, but because of the change in ratings methodology they have lower credit ratings. Given that banks are the largest issuers of credit in the short end of the curve, the relatively high yields on bank debt have led to higher yields in other sectors as well.
Market technicals should contain front-end curve steepening
Regulation of banks and money market funds will continue to funnel cash into the front end of the market, and these technical factors should contain the steepness of the front end curves. One interesting option is to think about segmenting their cash among money market funds and in investment vehicles further out the curve, where options include separately managed accounts (SMAs) and ultra short bond funds. SMAs can be customized to meet an investor’s particular guidelines. Ultra short bond funds vary with respect to duration, spread duration and permissible investments. Monthly, quarterly and yearly volatility are among the data points that an investor should examine when thinking about investing further out the curve.