As we approach the end of the year, we reviewed several of our theses from the TCH 2015 Outlook:
- On balance, we believe the U.S. economy will realize moderate growth in 2015
- There is broad consensus across investors, economists and monetary policymakers that the Fed funds rate will increase around mid-2015… Our expectations for the Fed funds rate are toward the lower and later end of market expectations. Further, we foresee the Fed maintaining its $4.5 trillion balance sheet and anticipate it continuing to reinvest principal payments
- Weak commodity prices—specifically within the energy sector—may further entrench current inflation expectations
- Perhaps the more significant risk remains China
Our projections were largely realized, though the last projection overwhelmed the first three. The U.S. economy did in fact manage moderate-but-unexciting growth in 2015. Inflation did remain low, in large part due to lower energy costs. In response to the uninspiring, but positive, growth the Fed did maintain its enlarged balance sheet and forestall a rate hike for the first 350 days of 2015. Anticipating market conditions of moderate growth, limited inflation and accommodative monetary policy, a constructive view on U.S. credit and maintaining portfolio duration were attractive positioning.
While those views were realized, it was in fact the Chinese economy that had the biggest impact on financial markets. A significant decline in the Chinese equity markets beginning in June led to global concern regarding a slow-down in Chinese growth. Declining Purchasing Managers’ Index (PMI) and Gross Domestic Product (GDP) numbers led to global growth concerns, the first U.S. equity market correction in four years and a broad-based increase in market volatility. In response to the slowdown, the People’s Bank of China (PBoC) has conducted six interest rate cuts during the last year and a half.
Commodity prices declined rapidly as global growth expectations were recalibrated lower. Exacerbating the situation for commodities, such as oil, were continued strong supply market dynamics. In this environment, credit spreads, particularly those for industries carrying the greatest sensitivity to these variables, widened significantly. Further, as the U.S. corporate bond market saw robust issuance throughout 2015, the record issuance contributed to an increased cost of funding and resulted in tighter overall financial conditions, despite the U.S. Federal Reserve remaining on hold longer than most expected.
U.S. monetary policy – then & now
In past cycles, market expectations for broad variables such as GDP, inflation, Treasury rates, mortgage and credit spreads would convey a reasonably homogenized view on the direction of the U.S. economy to policymakers. Looking back to our 2015 outlook, we expressed concern that inflation and employment were directionally at odds, meaning increasing employment was not being met with rising inflation expectations. Heading into 2016, this relationship is little changed, and has likely been exacerbated as falling commodity prices and a lower global growth outlook have weighed on inflation expectations.
While these factors kept the Fed at bay through most of 2015, the Fed language has been steady in its suggestion that current economic readings and its constructive outlook for long-term central tendencies are likely to converge. While inflation expectations have taken a strong stance against the Fed in this regard, the steady improvement in the U.S. output gap and the healthy growth in job openings provide a more balanced picture.
The question that remains unanswered: When will the labor market experience real wage growth? In our view, that is unlikely to occur during the first half of 2016, and may yet again struggle throughout the year. Without question, the supply side shock waves of the Great Recession left significant structural issues for the labor market in its wake. The prolonged period to absorb this magnitude of excess slack is unsurprising (though the impatience of some to accept this is).
With the Fed finally raising the fed funds target rate after six years with a zero percent lower bound, the U.S. enters the new phase of a rate hike cycle, albeit with the first step being the small increase in the target range to 25 – 50 basis points. While we project a very modest impact to the real economy, with an expected 1/2 to 1/3 of the increase being transmitted to the real output, we believe there will be a small impact relative to the increase in credit spreads, which have widened nearly 70 basis points since the middle of 2014.
Chair Janet Yellen has postulated that the current real equilibrium fed funds rate is around zero, implying a nominal equivalent of 1.25% to 1.5% based on core PCE inflation. We agree the U.S. economy has strengthened enough to warrant some temperance around the punch bowl; however, throughout 2016 we anticipate that pockets of volatility, geopolitical turmoil and murky U.S. fiscal policy remain constraints to growth. In our opinion, the equilibrium fed funds rate may be below, or towards the lower end, of this range. Accordingly, we also view a nominal fed funds rate of 1.25% to 1.5% as the likely upper bound for fed funds.
While the Fed’s forecast for central tendencies are higher than ours, we believe their sensitivity to downside risk remains elevated. Consider a comment from New York Fed President William Dudley, who pointed out that whenever the unemployment has increased by more than 0.3% to 0.4% from its low, it has been followed by a recession. In short, the Fed is aware that the cost of a policy misstep is high, hence we expect they will implement any monetary policy transition with a measured pace.
By contrast, the European Central Bank (ECB) expanded its easing program in December, extended the quantitative easing program by six months, with purchases remaining at €60 billion a month, and lowered the deposit rate from -0.2% to -0.3%. Yet this move disappointed markets and may need to broaden its reach again sooner rather than later. While financial and economic conditions in Europe have been improving, growth and inflation expectations remain too low, particularly when considering the heavy indebtedness of certain countries.
Similarly, with continued weak economic data, the likely near-term outcome in Japan is increased monetary easing, though the Bank of Japan has disappointed markets recently by failing to make such an announcement. The divergence of economic fundamentals and corresponding monetary policy between these developed regions and the U.S. led to and should continue to lead to dollar strengthening.
The U.S. economy should expand at a modest pace in 2016, though the readings between quarters are likely to remain choppy. Consumption (PCE), which accounts for 70% of total output (GDP), should be supported by improved labor market conditions and lower consumer energy prices; however, it would take a string of real wage increases to press growth meaningfully higher in 2016.
Though the U.S. economy is still constrained by some structural issues, it will likely lead growth among the developed economies. While this is an admittedly low hurdle, it should still result in a continued strong dollar as capital flows continue to seek shelter from the negative-to-low yields permeating other developed markets (e.g., Europe and Japan).
Following a rough 2015, commodity prices should stabilize, but a sharp recovery in 2016 is unlikely. The developments that led to commodity price declines—namely concerns surrounding the Chinese economy and supply/demand imbalances—are structural and show little signs of abating over the near term.
As we look towards 2016, we believe the key determinant of success for investors will be how well one can look beyond monetary policy cycles. After all, the notion of rising interest rates has been studied by the bond market for several years now; however, it has come at the expense of overlooking market dynamics and economic underpinnings, which have evolved in a meaningful way over that time. In our view, it is the responses to these topics that are stuck in the crosscurrents, which will have a larger impact on fixed income markets than monetary policy alone.
Investment Strategy Implications
The Fed’s reinvestment policy has not been the sole determinant of yield spreads for U.S. agency mortgage-backed securities (MBS); in fact, the net supply of agency MBS turned out to be higher than the market’s expectations. Despite this, agency MBS spreads tightened throughout 2015, and for the first time since 2012, agency MBS purchases by institutional investors such as banks and savings institutions exceeded that of the Fed.
The likely performance drivers for agency MBS were its favorable liquidity profile relative to similar duration credit and comparably lower volatility compared to U.S. Treasuries. In short, agency MBS proved once again to be a safe haven, a profile that we believe will persist in 2016; however, given their relatively tight valuations, we believe total return opportunities are stronger in other sectors.
The repricing of credit risk that occurred throughout 2015 has created compelling opportunities within U.S. investment grade credit, particularly if one assumes a global perspective. Environments in which credit spreads widen indiscriminately have proven to be those in which we uncover some of our best ideas for long-term risk-adjusted performance. For instance, when a decline in commodity prices pressures valuations across a given industry equally, it assumes that the impact on a given issuer’s creditworthiness is also undifferentiated. Stress-testing factors such as these is a core tenant of our investment process; therefore identifying opportunities that have been disproportionately affected relative to their underlying fundamentals is at the heart of relative value process. While we anticipate that volatility will persist, we are excited by the prospect of capturing yields that seemed unimaginable only a year ago.
Accordingly, between the more favorable outlook for the U.S. economy (among developed economies) and the extra yield pick-up relative to similar duration and credit quality alternatives, we anticipate the U.S. investment grade will continue to attract capital flows from abroad. USD corporates derive 60% of revenues from North America and improving conditions should be supportive of the sector. Over the course of the year, we anticipate that the relative attractiveness of certain credit subsectors will lead to some normalization and additional stability for credit spreads. One area where we remain cautious is the propensity for investment grade corporations to undertake corporate finance decisions (e.g., mergers and acquisitions, shareholder activism), which benefit near-term earnings and margins at the expense of longer-term credit quality.
High yield defaults increased in 2015, but thus far have largely been confined to energy and commodity sectors. Despite recent headlines, in our view, the near-term risk of real contagion remains limited as the corporate credit markets remain healthy. Given that the absolute yield for high yield remains well below its historical average, we remain cautious on drifting too low on the quality spectrum. Since the magnitude of the repricing between energy and commodity sectors has been rather even-handed between investment grade and high yield, we believe the more compelling opportunities in high yield are in other sectors where the disconnects between valuation and fundamentals are more idiosyncratic (issuer specific) and less systemic (linked by a common thread, e.g., oil, copper price).
Elsewhere in the “beta” sectors, weak commodity prices and a slowdown in key emerging market economies have taken their toll on emerging market debt. While this has undoubtedly created additional opportunities, the geopolitical climate has become increasingly complex across multiple regions. Accordingly, the risk-reward spectrum continues to favor opportunities within developed markets, particularly U.S. investment grade credit.
Global economic weakness and uncertainty abound. Once again, U.S. growth is likely to remain the oasis in an otherwise turbulent environment. We continue to believe that the U.S.’s relative economic strength combined with widening monetary policy divergence from other developed nations positions the U.S. fixed income markets as an attractive asset class globally. After a difficult year for credit and the undifferentiated credit widening in the third quarter, significant opportunities within U.S. investment grade credit exist at the sector and security level.
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