We remain constructive on U.S. growth and labor market strength, and we believe the Fed may begin raising rates sooner than the market expects, possibly in September of this year.
We do not think the magnitude of the dollar's rise is sustainable, but find conditions for active currency strategies to be attractive.
We continue to prefer prepayment, credit, and liquidity risks over interest-rate risk across fixed-income portfolios.
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- Market themes
- Sector views
Some temporary setbacks to growth
We remain positive about U.S. economic growth, but the recovery has reverted to a moderate pace after surging in the middle of last year. Many estimates of first-quarter gross domestic product (GDP) are around 1% annualized, and some are well below that number. The weather is somewhat to blame, as is the temporary shutdown of West Coast ports. While our own research shows the deceleration is due in part to those factors, we believe the driving force behind the slowdown is the consumer, who, contrary to expectations, is saving rather than spending newfound income.
Where in the world is the U.S. consumer?
Early in the post-crisis era, the recovery of financial assets and the rebound in real estate prices largely tended to benefit higher-wage earners. But over the past year or so, rising wages among lowerincome workers raised expectations that consumption would show new signs of strength, just as lower gas prices — which at current levels add, according to some estimates, roughly $1,500 per year to the disposable income of the average U.S. family of four — were expected to boost consumers' ability and willingness to spend.
But consumers appear to be saving their money. The question is what are they saving for. While retail sales have been rather weak, goods are only one part of the consumer-spending basket. Households also spend on services, and key parts of spending on services — such as housing — are growing quite steadily now. While steady growth is not booming growth, housing data are tolerably strong almost everywhere in the United States, and the recent rise in the household formation rate is pushing up spending on housing. Thus, if consumers appear to be missing, it may well be that they are busy planning a future home purchase — or, at least, moving out of a multifamily home and into a new rental. Future buyers and renters thus have the potential to push up aggregate housing demand.
The Federal Reserve's pursuit of policy autonomy
As the growth picture has evolved, the Fed has been slowly recapturing its policy autonomy. Key thresholds were crossed in the fall of 2014 with the end of quantitative easing, and then, most recently, with the Fed's pullback in its prior commitment to be "patient" as it edges toward its first rate-raising decision.
In our view, the Fed has done much work on the practical aspects of changing its course, developing policy tools to absorb the large excess reserves that now sit in the U.S. financial system. Overall, we read this as proof that the Fed believes economic and financial conditions no longer warrant emergency levels of monetary support. Indeed, the Fed expects that a slow process of tightening is highly likely to begin in the next six to nine months. And we believe the Fed will hike rates sooner than the market expects.
Reading between the lines: labor and the dollar
Importantly, the most recent Federal Open Market Committee meeting minutes reveal that there are still two potential obstacles to a change in policy: the labor market and the dollar. The timing and pace of Fed moves will be determined by strength or weakness in these areas.
Our research underscores how the labor market continues to heal, but we also find that wages are not as strong as they could be. The Fed takes an optimistic view about the ability of the job market to push participation rates back up, whereas we think an improvement in labor participation is more difficult to see. Data on the intractably large amount of marginally attached workers, for example, have not moved much since the early days following the financial crisis. Nevertheless, labor's recovery has indeed taken shape, and thus we think this will not pose too large an obstacle to Fed action.
For the Fed, the dollar's impact on the U.S. inflation outlook is probably more important than its effect on GDP. Our rule of thumb is that a 10% appreciation of the dollar could shave roughly 0.2 percentage point off GDP growth after six or nine months; for inflation, it is harder to have such a rule of thumb, but a further upward move in the dollar would probably be associated with strong deflationary pressure coming from the rest of the world. And if the Fed saw its own forecasts of inflation slipping by two tenths of the percentage point or so, policymakers could easily opt to exercise some patience with respect to a rate increase. We think the dollar will struggle to rise by much more than it already has, but this is a risk to keep in mind.
Currency movements argue for active strategies
Over the last year or more, we have seen the reemergence of traditional drivers of currency strategies, and thus currency has played — and we expect it will continue to play — an important role in many of our fixed-income portfolios.
Capital flows and rate structures
There are two primary drivers in this area. The first is economic growth differentials: The better the growth in a given economy, the more capital will flow in, and the stronger the currency will typically become. The second is interest-rate differentials, which we believe may continue to grow as the year progresses.
These two factors were more or less suppressed in the recovery itself, simply because the recovery has been sporadic and repeatedly in question. Strong cyclical dynamics took a long time to become established. Now that the United States and other countries, such as the United Kingdom, have ended quantitative easing, traditional signals of economic growth and rate structure difference are becoming stronger.
The United States, for example, is clearly outgrowing much of the developed world — and some of the developing world, as well. What's more, interest-rate differentials are starting to show up in the front end of the yield curve. This led us, particularly in May or June of last year, to begin introducing a more active currency strategy set into fixed-income portfolios, which were important contributors to performance for the balance of 2014. That trend continued into the first quarter of 2015, and looking ahead, we think it will continue to offer diversifying potential to fixed-income investors.
Risks around the world
The main issue we see hanging over the global economy is China. Chinese authorities have effectively conceded that they have lost the tight control over the economy that they once enjoyed, and they seem to be disconcerted by the current pace of growth. It is not at all clear that China will come off the rails, but this is a possibility we cannot ignore.
The second risk is Greece, where the Greek government is dangerously close to failing to live up to both its promises to its constituency and to its contractual responsibilities with its creditors. We continue to think there is ample scope for a compromise, as well as a strong incentive to succeed at finding a middle ground: fear of what would happen if a compromise cannot be made.
The third risk is in emerging-market outflows. Capital continues to leave emerging markets at great speed, and while it is far from a uniform flow across countries and different assets, it is moving in large volumes and it appears set to continue. This puts a lot of stress on the developing world, where capital inflow is frequently required to keep growth going.
Our mortgage credit investments, specifically positions in subordinated mezzanine commercial mortgagebacked securities (CMBS) and non-agency residential mortgage-backed securities (RMBS), performed well in our multi-sector strategies and dedicated mortgage portfolios. Mezzanine CMBS benefited from supportive commercial real estate fundamentals amid an improving U.S. economy, 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 its values were supported by consistent investor demand, benefiting our holdings of pay-option adjustable-rate mortgage-backed securities.
Overall, our prepayment strategies delivered positive results, led by successful trading strategies using agency pass-throughs. However, strategies that were implemented with securities such as agency interest-only collateralized mortgage obligations (IO CMOs) slightly detracted.
In January, the Obama administration announced that the Federal Housing Administration (FHA) would reduce the annual mortgage insurance premiums it charges to borrowers making small down payments. Investors reacted to this development by pricing in the possibility of faster mortgage prepayment speeds, which dampened the returns of existing prepaymentsensitive mortgage-backed securities. What's more, this announcement came during a time when interest rates were declining, compounding the negatives for IO CMOs. The asset class rebounded in February, but could not fully overcome January's sharp downturn.
We expect to maintain our holdings of IO CMOs. We do not believe the new FHA policy is likely to have a major impact on the overall pace of residential refinancing. What's more, we continue to find prepayment risk attractive, given the potential for higher interest rates as the U.S. economic recovery matures.
Data are provided for informational use only. Past performance is no guarantee of future results. All spreads are in basis points and measure optionadjusted yield spread relative to comparable maturity U.S. Treasuries with the exception of non-agency RMBS and mezzanine CMBS, which are loss-adjusted spreads to swaps calculated using Putnam's projected assumptions on defaults and severities, and agency IO, which is calculated using assumptions derived from Putnam's proprietary prepayment model. Agencies are represented by Barclays U.S. Agency Index. Agency MBS are represented by Barclays U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by Barclays U.S. Corporate Index. High yield is represented by JPMorgan Developed High Yield Index. CMBS is represented by both Agency and Non-Agency CMBS that are eligible for inclusion in the Barclays U.S. Aggregate Bond Index; mezzanine CMBS is represented by the same index using the AA, A and BBB components. Average OAS for Mezzanine CMBS is for the 2000-2007 time period. Emerging-market debt is represented by the Barclays EM Hard Currency Aggregate Index. Non-agency RMBS is estimated using average market level of a sample of below-investment-grade securities backed by various types of non-agency mortgage collateral (excluding prime securities). Mezzanine CMBS is estimated from an average spread among baskets of Putnam-monitored new issue and seasoned mezzanine securities, as well as a synthetic (CMBX) index. Agency IO is estimated from a basket of Putnam-monitored interest-only (IO) and inverse IO securities. Option-adjusted spread (OAS) measures the yield over duration equivalent Treasuries for securities with different embedded options.
Investment-grade bonds: Relative resilience to oil price decline
In January, the combination of a stock market pullback, weaker-than-expected U.S. economic data, and continued worries about deflation in Europe fueled investors' appetite for government bonds. As a result, the yield on the benchmark 10-year U.S. Treasury fell from 2.17% at the beginning of the month to 1.68% at the end. In February, however, concern that the Fed might start raising its target for short-term interest rates in June hampered Treasuries, causing prices to fall and yields to move higher.
Overall, investment-grade bonds delivered positive returns, as they benefited from a backdrop of low rates and the slowly forward-grinding U.S. economic advance. Corporates generally have what we believe are strong cash flow generation, high margins, large cash balances, and no signs of dangerously high leverage, all of which underscore the relative stability of these issuers. In addition, unlike other areas of the fixed-income markets, such as high-yield and emerging-market debt, investmentgrade bonds have, thus far, not been as susceptible to the risks posed by dramatic weakness in oil prices.
High yield and bank loans: Fundamentals still in place
In the high-yield sector, investors sometimes wonder what will happen if oil prices stay low or decline further, which is a good question to ask as energy makes up roughly 15% of the high-yield market. Exploration and production companies and the businesses that service them have been the most affected by the drop in oil prices. Within this group, the higher-cost producers with strained balance sheets that are insufficiently hedged are at the greatest risk of default over the next 18 months should oil prices stay low or fall further.
However, this subgroup represents only about 3% to 4% of the market. So, in the unlikely event that all of these companies default, the market impact would be more or less in line with the historical average default rate for the high-yield market as a whole. What's more, most of the rest of the high-yield market, and the U.S. economy generally, should benefit from lower energy prices.
Corporate fundamentals remain solid
Because we believe that the U.S. economy remains solidly in the midcycle phase of expansion, we see the economy providing a supportive backdrop for domestic corporate fundamentals. Against this backdrop, outside of the energy sector, most high-yield issuers appear to be in reasonably good financial shape. Corporations continue to take a conservative approach toward managing their assets and liabilities. This can be seen by the fact that most of the recent new-issue activity was for refinancing existing debt, which has helped issuers lower their overall borrowing costs.
At period-end, the par-weighted high-yield default rate was 3.00%, down slightly from 3.06% in February, which was the highest rate since May 2010. For context, the default rate was 0.61% a year ago, and it is expected to fall in April when bankrupt electric utility TXU Energy is removed from the default calculation. Excluding TXU, the default rate was 1.70%. We believe the default rate is likely to remain low overall. With valuations improved after the recent market selloff, we believe the yield advantage that high-yield bonds provide over U.S. Treasuries offers the potential for attractive loss-adjusted returns versus other fixed-income alternatives.
Bank loans show healthy market dynamics
In the bank-loan market, lower loan prices have dampened refinancing activity, meaning there is reduced risk that loans held by the fund will be redeemed before their maturity dates, helping to stabilize the portfolio's coupon income. At the same time, lower loan prices may offer the possibility of modest capital appreciation in the months ahead.
Collateralized loan obligation (CLO) issuance may continue to provide a significant source of demand for bank loans. Additionally, if interest rates were to rise meaningfully in 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: The weak may grow weaker
Our holdings of emerging-market debt generally performed well in the first quarter, led by positions in Argentina, Russia, and Venezuela. Stabilization in oil prices along with a February cease-fire in Ukraine aided the performance of our investments in these markets.
Despite this performance trend, there is genuinely more uncertainty — which we share — about economic health in the developing world. PMI indices have been trending down for most emerging markets for a few months now. Apart from Poland and a couple of other central European economies that are benefiting from an upswing in Germany, emerging markets are struggling. Overall, we are focused on specialized opportunities in the emerging markets, particularly where idiosyncratic risks appear sufficient to provide some independence of what happens at the Fed.
China and dollar strength pose key risks for emerging markets
China's slowdown affects many of its regional neighbors even as it drives capital from China itself. Elsewhere, there are ongoing political shocks affecting Russia and Brazil. And commodity price declines, obviously linked to China's weakness, are harming economies such as South Africa and Peru. In general, weaker exchange rates and central bank rate cuts have not entirely offset these forces and argue for greater caution.
We are increasingly concerned, moreover, that defaults, especially on corporate debt, are likely to rise sharply in emerging markets. Many companies rely on export earnings, and thus access to dollars, and for them, dollar indebtedness may make sense; but there are others whose repayment obligations, in light of exchange rate moves, may well become crippling.
Municipal bonds: All eyes on the Fed
After a strong start in January, which came on the heels of a solid 2014, municipal bonds encountered increased volatility in February and March. Uncertainties surrounding the timing of the Fed's first rate hike since June 2006 contributed to heightened interest-rate volatility, as did growth worries and diverging central bank policies around the globe. Against this backdrop, municipal bonds moved directionally with U.S. Treasury bonds and delivered a positive return as measured by the Barclays Municipal Bond Index.
With interest rates low and fundamental credit quality stable, investors continued to seek out the yields offered by the relatively riskier municipal bonds further out on the maturity spectrum as well as for those in the lower-rated, higher-yielding sectors. Consequently, credit spreads tightened during the quarter, resulting in slightly better returns for lower-quality investments than for higher-quality investments.
Municipal bond prices also benefited from favorable technicals, as inflows continued throughout the quarter. While supply is up significantly year over year, it has been dominated by refunding issuance, as municipal issuers replaced their older, higher-coupon bonds with lower-yield debt. The increased supply has generally been met with strong demand.
Energy price impact on oil-producing states
Lower oil and energy prices should be a net positive for the municipal bond market, in our opinion. Certain sectors, such as transportation — notably airlines — and toll roads, could see a positive impact from the decline in prices. However, we believe that oil-producing states, such as Texas, North Dakota, and Alaska, are likely to see falling revenues as production decreases or ceases for a period of time.
In the cases of Alaska and North Dakota, however, these states do not issue much municipal bond debt and have set aside healthy reserves to ease budget pressures that typically accompany such a downturn. In the case of Texas, we believe the decline in oil and energy prices is likely to be more widely felt. If oil prices remain low for an extended period of time, affected issuers may come under more pressure and be subject to credit downgrades or defaults. The susceptibility of local government obligation (G.O.) bonds to macroeconomic developments, such as a sharp decline in oil prices, reinforces our predisposition to underweight G.O. bonds in our municipal bond portfolios relative to the Barclays Municipal Bond Index.
Defaults and tax reform are not big sources for concern
The general fiscal health and creditworthiness of the municipal bond market is solid, in our opinion. Despite some high-profile outliers, such as Detroit and Puerto Rico that have garnered much media attention, defaults are expected to remain low and could even decline further as the U.S. economic recovery matures.
Ultimately, prospects for tax reform appear to constitute little risk at this point, in our opinion. However, we are closely monitoring the various proposals and believe any momentum for change will more likely come after the 2016 elections.
Currency: No threats to the strong dollar
Within active currency, our U.S. dollar strategy favors a modest overweight. The pillars for U.S. dollar strength are based upon relative growth outperformance, the subsequent implications for the attractiveness of U.S. assets, and relative monetary policy.
For the dollar–euro strategy, we have moved toward a more neutral position. Growth in the eurozone continues to improve and shows signs of stabilizing at modest levels, and inflation readings have recovered somewhat, although there remains some skepticism about the ECB's credibility on inflation targets.
We favor a slightly longer position versus the British pound sterling. In the United Kingdom, growth levels remain solid while inflation and inflation expectations have come down considerably. This has seen the market push out expectations for the first rate hike until mid-2016, putting pressure on the pound against the dollar. Looking ahead, politics remains worrisome: A parliamentary election will take place in May, and the potential outcomes dictate a negative bias against the dollar.
Currently, we favor a moderate short position for the Japanese yen. The Bank of Japan (BoJ) has demonstrated its resolve to reflate Japan, and at its latest meeting, BoJ Governor Kuroda made clear that there are no plans to ease its stimulus policy, and that the bank is prepared to adjust its policy if the early achievement of the inflation target is found to be difficult.