The U.S. economy has put first-quarter weakness behind it, while European and Japanese data continue to improve slowly.
Risks around Greece have diminished, while China and other emerging markets exhibit high levels of political and economic risk.
We continue to prefer prepayment, credit, and liquidity risks to interest-rate risk across fixed-income portfolios.
Bill Kohli, Co-Head of Fixed Income, explains why he expects higher market volatility for the near term.
Higher market volatility for foreseeable future
Bill Kohli, Co-Head of Fixed Income, explains why he expects higher market volatility for the near term.
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U.S. growth anything but weak
According to the latest revised growth data, first-quarter U.S. GDP growth was -0.2%, which, although weak, was better than previously forecasted. In addition, consumption data rebounded in recent weeks, alleviating concerns that first-quarter weakness was sending a troubling message about underlying economic fundamentals. Based on current estimates of U.S. growth, GDP has moved above a seasonally adjusted annual rate of 3%, a pace we believe is sustainable for the remainder of 2015.
Of course, this outlook may face headwinds if the U.S. dollar resumes its upward trajectory, which could happen as a result of a deeper China slowdown or an adverse outcome for Greece and the eurozone. Although the latter is still possible, its likelihood decreased after the July 13 announcement of the agreement between Greece and the European Commission (EC), European Central Bank (ECB), and International Monetary Fund (IMF).
Overall, the underlying strength in the U.S. economy gives us reason for optimism, as the pace of job creation is decent, and wage gains may push inflation toward the Fed’s target of 2%. Although a less robust June labor report reduced the probability the Fed will hike rates in September, we believe it would take a drastic deterioration in economic prospects to cause the Fed to wait until 2016. We believe that an improving labor market, momentum in wage growth, and stable dollar strength are likely to lead to a rate hike later this year.
Even amidst the strengthening U.S. economy, the debt crisis in Greece dominated headlines during the second quarter. This contributed broadly to investor risk aversion, pushing spreads wider across most fixed-income sectors.
Although Prime Minister Tsipras struck an agreement with the EC and ECB for a third bailout fund, he now faces political hurdles to navigate a gradual recovery for the Greek economy. A continuation of austerity policies, which include pension reform and further taxation, may pose a challenge for Tsipras and his Syriza party.
The troubled path to achieve agreement with creditors created fractures in the eurozone itself, sending tremors through the monetary union that still appears to be contingent on domestic political developments. The implication for the future is that riskier sovereign bonds in the eurozone may require higher risk premiums.
Why do Chinese policymakers care so much about stocks?
News about Greece nearly overshadowed events in China. In June, China’s central bank implemented another cut in interest rates and reduced the reserve ratio requirement for banks. We think this is a sign that Chinese policymakers are not seeing the improvement in economic growth that they expected, given the level of monetary stimulus they provided over the past 12 to 18 months. The easing policy was also meant to arrest the steep decline in Chinese stocks that began in mid-June.
Given that the stock market losses are not as impactful to the economy — only a relatively small number of people in China own stocks — it raises concerns about Chinese policymakers’ intense interest in stocks. The government’s initial concern was likely to minimize the risk to consumer confidence and to mitigate the potential for popular discontent as a result of the rapid market decline. However, after placing such an emphasis on the stock market, we think the government risks becoming hostage to it.
From an economic perspective, China dwarfs Greece on a GDP level. Although we don’t believe China’s economy will suffer a substantial slowdown, such a scenario would have far greater implications for global markets than a reprise of the Greek drama or even a potential "Grexit."
Fixed-income asset class views
Generally speaking, we were positioned for a rising interest-rate environment in the second quarter, which was a strategy that worked well across a variety of our fixed-income portfolios. Specifically, we kept duration — a key measure of interest-rate sensitivity — shorter than that of the Barclays U.S. Aggregate Bond Index, meaning many of our portfolios were comparatively less sensitive to rate fluctuations. This positioning yielded positive results as rates rose in May and June.
As we discuss in this section, a number of fixed-income asset types continued to make gains in the second quarter, though performance was choppy at times. Risk-averse investor behaviors promoted higher short-term correlations between typically uncorrelated asset classes, such as commercial mortgage-backed securities (CMBS) relative to high-yield and investment-grade corporate bonds. Against the backdrop of what we consider to be the inevitable approach of higher rates, we remain optimistic about non-interest-rate forms of fixed-income risk, including prepayment, credit, and liquidity risks.
Securitized debt: Broadly positive results
Our prepayment strategies, which we implemented with securities such as agency interest-only collateralized mortgage obligations [IO CMOs] performed well in the second quarter. As interest rates moved higher in May and June, mortgage refinancing became less attractive, resulting in slower prepayment speeds.
Our mortgage credit investments, specifically positions in subordinated mezzanine CMBS and non-agency residential mortgage-backed securities [RMBS], also performed relatively well. Mezzanine CMBS benefited from improving commercial real estate fundamentals, along with persistent investor demand for higher-yielding bonds. Non-agency RMBS were helped by strong supply-and-demand dynamics. The universe of investable securities continued to shrink, but their values were supported by consistent investor demand, benefiting our holdings of pay-option adjustable-rate mortgages (ARMs).
Investment-grade bonds: Continued stability
Corporate fundamentals are still solid. Investment grade corporate balance sheets and profit growth may have peaked but there does not seem to be a major deterioration in credit. Leverage within investment-grade corporates as a whole is rising, but it is mostly increasing at higher-quality companies and in specific sectors. June supply was lighter than previous months as some deals may have been delayed in the face of Greek volatility. Spreads widened by 12 basis points during the month to end at 145. The team believes that spreads can compress in 2015 given the solid underlying credit fundamentals, but global economic concerns, falling oil, geopolitical headlines, and/or volatile and rising U.S. Treasury rates may drive spreads wider in the near term.
In addition, unlike other areas of the fixed-income markets, such as high-yield and emerging-market debt, investment-grade bonds were not as susceptible to the risks posed by weak oil prices, and should continue to weather any reappearance of weakness in the commodity price cycle.
High yield and bank loans: Improved fundamentals
High-yield bonds delivered positive performance for the quarter, despite headwinds in June. The asset class rallied strongly in April and early May as rising oil prices reduced the pressure on energy companies that were at the greatest risk of defaulting when prices were lower. Recently, technicals have suffered. However, we continue to be constructive on high-yield corporate credit, where we see improving fundamentals, a continued low default rate, and, most importantly, the ongoing solid backdrop of the U.S. economic expansion.
In the bank-loan market, renewed investor demand for higher-yielding securities amid lower bond yields globally, exacerbated by a light supply of loans, bolstered the asset class in April and May. Loans also benefited from moderating retail fund outflows and continued robust demand from collateralized loan obligations — structured investment vehicles in which loans are pooled to create a diversified income stream. In June, bank loans suffered their first negative monthly performance in 2015 amid increased global volatility, but held up better than most other asset classes.
We think the economic backdrop should be generally supportive for the asset class. Regulators have begun to focus more intently on the quality of new loans, particularly the amount of leverage relative to an issuer’s cash flow within each loan. In our view, these efforts are likely to improve the quality of newly issued loans.
Additionally, if interest rates were to rise meaningfully in the second half of 2015, the asset class would likely benefit from renewed retail investor demand since bank-loan coupons — their stated interest rates — may begin to adjust higher.
Emerging markets: Outflows continue
While emerging markets endured the challenging condition of capital outflows, emerging-market debt (EMD) registered positive absolute returns during the quarter, outperforming a variety of fixed-income asset types. Higher interest rates in developed markets — and expectations for more of the same — led many investors to reallocate their assets away from emerging markets, which warrants caution in the months ahead.
Broadly considered, higher interest rates can be a challenge for any fixed-income market. But when advanced economies see their interest rates rise, capital tends to flow in, in pursuit of higher yields with lower perceived risks. That dynamic began to play out during the second quarter as the U.S. economy continued to improve and the U.S. Federal Reserve began to prepare markets for an increase in the federal funds rate.
Of the various types of EM investments, stocks bore the brunt of the adverse effects from the capital reallocation, though local debt, dollar-denominated debt, and EM currencies all experienced weakness. Having said that, EM government debt performed better than U.S. Treasuries, while EM corporate debt wound up in positive territory as bond spreads in this sector tightened and the securities gained in value. Oil prices did appear to find more solid footing, as did copper prices, which gave a number of commodity exporters more flexibility in terms of making debt repayments.
The rebound in the price of oil particularly helped big oil producers such as Russia — where asset markets have recently performed well despite continued Western sanctions — and Venezuela, both of which had suffered economically from oil’s dramatic price slide beginning in mid-2014. Our position in Russian government debt, as well as our position in quasi-sovereign Russian debt, including debt issued by government-run banks and energy companies, performed well.
More broadly, throughout the current commodity price cycle, we believe that EM countries and companies have kept their credit profiles in decent shape. A useful comparison in this regard is the economic environment in the United States during the financial crisis of 2008. In the wake of that event, the U.S. economy slowed fairly dramatically, and in fact it still has not grown consistently since that time. But since then, the U.S. corporate sector has become much stronger in terms of building cash balances and expanding operating margins — and all of this has happened in the absence of consistently robust growth. We have observed similar dynamics with respect to EM corporates, and we note the resilience of many companies in this segment of EMD during the period.
Overall, we are cautious about the broad prospects for EMD in the near term. High-yield markets struggled near the end of the period as Treasuries rose, and that may be a harbinger of difficulty for EMD insofar as it represents a segment of the global credit market. We believe that investors should be prepared for some volatility in the EMD asset class, which could be amplified by continued capital reallocation as the global interest-rate picture changes.
Municipal bonds: Volatility picks up
Municipal bonds encountered increased volatility during the second quarter amid uncertainty about the Fed’s timetable for expected rate increases and some well-publicized news of cities and states facing inadequate pension-funding liabilities. The asset class returned -0.89%, as measured by the Barclays Municipal Bond Index, but outperformed Treasuries despite some outflows from the asset class. Credit spreads (the difference in yield between higher- and lower-quality municipal bonds) widened somewhat during the quarter but still remained fairly tight — reflecting the generally improving economic backdrop.
Technicals in the tax-exempt market were fairly stable in the first half of 2015. Supply has been relatively heavy — almost 50% higher than in the first half of 2014. The bulk of new issuance has been for refunding, or refinancing, activity as municipal issuers took advantage of the low-interest-rate environment to replace their older, higher-coupon bonds with lower-cost debt. So the supply side is still robust despite some hesitancy on the part of state and local governments to issue new bonds, as they turn their attention toward funding employee pensions and other fixed costs in their budgets. On the other hand, demand has been fairly decent. That said, the municipal bond market did begin to experience outflows in May and June as a timeline for Fed action on a rate hike came into clearer focus.
Given expectations for a Fed rate increase, economic trends in the broader U.S. economy, and technicals in the municipal marketplace, we continue to manage tax-exempt portfolios with a defensive bias. Along with recent outflows from municipal bond funds, as well as negative headlines associated with Puerto Rico, Chicago, and Illinois, we are positioned for modestly higher rates going forward.
That said, we continue to see pockets of investment opportunity, particularly in the essential-service revenue sectors, such as higher education, health care, transportation, and utilities. The portfolios have a little less duration sensitivity than their Lipper peer groups. We accomplish this posture in part by holding a slightly higher cash position to help shelter the portfolios from price pressures while also providing some liquidity to act swiftly should timely investment opportunities present themselves. Given our longevity in the business and our experience through many market cycles, we have learned that there still are opportunities to invest during a rising-rate environment. Markets can become disjointed and create opportunities to buy bonds at attractive spreads, as nervous investors react to the headlines rather than fundamentals.
Currency: Though less ascendant, the dollar still holds advantages
Within active currency strategies, our U.S. dollar position is a more modest overweight. The pillars for U.S. dollar strength are based upon relative growth outperformance and the subsequent implications for attractiveness of U.S. assets and relative monetary policy. The U.S. growth story has stabilized at more moderate levels, but on a relative basis it is not the standout leader as other major economies have seen improvement as well. The United States is regaining equity-market leadership, and it remains an attractive destination for fixed-income capital with the Bank of Japan (BoJ) and the European Central Bank (ECB) actively purchasing local government debt.
While maintaining this long-term view on the dollar, we note that the euro has some short-term advantages. Growth in the eurozone has stabilized at modest levels. The ECB policy remains easy. The current situation in Greece remains fluid and provides a great deal of volatility for the single currency. A more benign outcome (which is our base case) in which Greece agrees to additional austerity measures and receives a new financial assistance program from creditors should see the single currency move higher in the short run. A Greek exit would likely cause quite a bit of financial market volatility and would require the official sector, particularly the ECB, to ensure the monetary policy transmission channel remains functional through even more extensive purchases of sovereign debt (on top of its current quantitative-easing program), which should see the single currency drop precipitously.
While still at a disadvantage versus the dollar, the British pound sterling benefits in the near term from U.K. growth levels remaining solid. Although inflation and inflation expectations have come down considerably, they appear to have reached a trough. Additionally, the labor market data is showing signs of wage pressure, and the hawks on the Bank of England Monetary Policy Committee could start to voice the need for rate hikes in coming meetings.
Regarding the Japanese yen, we still favor a modest short. BoJ Governor Kuroda continues to highlight that the BoJ does not have any intention to ease the policy near term given the current economic and price conditions, explaining that the decline in core CPI (consumer price index) inflation is temporary and could be reversed in line with oil price developments. Most importantly, Kuroda stresses that the BoJ will not hesitate to adjust the policy if fundamental price trends change and if the early achievement of the inflation target is found to be difficult. This very easy policy (and expectations that more will be needed) coupled with the Fed lifting rates sooner and faster than the market expects should continue to keep pressure on the yen.