(Yes, this is the seventh installment of our Fixed Income Insights commentary.)
Since the turn of the year, global financial markets have focused seemingly exclusively on China. While the China story has driven risk appetite and sentiment since then, much like it did in the third quarter of 2015, the fourth quarter saw a brief respite from the China slowdown story and focus was largely placed on major policy announcements — from Federal Reserve (Fed), the European Central Bank (ECB) and the Organization of Petroleum Exporting Countries (OPEC) — especially in December.
On December 17, the Fed announced that after seven years of zero percent (lower bound) rate for the Fed Funds rate and nine years since the last hike, that it would be raising the Fed funds target range by 25 basis points (bps). Despite the September introduction of ‘global concerns’ as a determinant for rate hikes, the Fed had been talking up a 2015 rate hike for many months, effectively locking themselves into a position where they had to act. The continual emphasis on a hike in 2015 did accomplish one of the Fed’s primary objectives: by the time the Fed raised the Fed Funds rate, futures were projecting a better than 75% likelihood of such an action.
The new range of 25 to 50 bps hardly represents a dramatic increase, but with years of anticipation behind it, the question was how would the market handle the beginning of a new phase of monetary policy? The market was pricing in the move per the Fed’s continual guidance and after the September statement, which has been viewed as a misstep by Fed, the December action was received as intended by the U.S. central bank.
Interestingly, the Fed’s “dot plot” – the anonymous projections of Fed governors – still calls for four rate hikes over the next year. While the language of the statement has generally been interpreted as dovish, this is a rather hawkish projection. Especially when viewed in the context of the Yellen Fed’s hesitance to initiate the rate hike cycle, four hikes seems unlikely in our view. Since the end of the year, market projections have decreased from two to one additional hike in 2016.
With inflation low and limited upward pressure on the horizon, what could prompt four rate hikes in 2016 would likely be higher-than-expected growth, a situation we would welcome. More likely, the estimate is aspirational rather than a summary of expectations.
Why would a bond manager be happy about a rate hike?
Monetary policy transitions are notoriously difficult for performance of the non-governmental fixed income sectors. Specifically, the period preceding the transition has historically seen underperformance of credit as market concerns about the possible disruptions a transition could cause trump what otherwise should be positive conditions for credit, namely positive economic growth.
This cycle in particular, it has been difficult to pinpoint when the Fed would act. For example, the Fed twice lowered the unemployment target at which they would lower rates before shifting to a broader statement of being ‘data dependent.’ As such, avoiding credit would have carried a significant opportunity cost over the past several years. Similarly, shortening duration in anticipation of a rate hike, a strategy many have tried for the past five years, carried a significant cost as the supposedly imminent rise in rates never materialized.
Now that we have officially entered a new phase of monetary policy with the Fed’s rate hike, we look to history once again as a guide. Spread sectors, especially credit, have performed well in the post-transition period. From our perspective then, the biggest news is not the 25 bps hike, but the removal of the uncertainty of a policy transition. With increased clarity in U.S. monetary policy, we expect a positive result for U.S. fixed income markets, though we caution that global volatility is unlikely to abate near-term.
Going the other direction
By contrast, while the U.S. has turned a policy corner, the ECB is far from a tightening cycle. The ECB extended its quantitative easing program by six months, which at €60 billion per month, is a total of €360 billion worth of additional new central bank purchases. It also lowered the deposit rate by 10 bps, from -0.20% to -0.30%. As the deposit rate is also the yield threshold below which the ECB will not buy securities, it also expanded the pool of assets the ECB could buy and potentially push yields lower for those securities.
Conditions in Europe are such that even the additional purchases and lowered deposit rate were viewed as a disappointment by the market, which was expecting more significant policy accommodation. Similarly, the Bank of Japan (BOJ) has twice been expected to increase its monetary easing and has declined to do so though economic conditions in Japan face perhaps the most severe low inflation and growth expectations of the developed nations. In a surprise move on January 29, the BOJ lowered the deposit rate on excess reserves to -0.10%.
Since the end of the year, Mario Draghi, President of the ECB, reiterated his willingness to use the full might of the ECB. Draghi has effectively used moral suasion in the past to accomplish his goals, perhaps better than the actions of the ECB itself could do. He has now suggested there are ‘no limits’ to the policy options at the next meeting in March.
The China slowdown
Though monetary policy in the developed market has been a key theme throughout the year, the second half of 2015 and indeed the start to 2016 has been largely dominated by the economic slowdown in China and its broad reaching consequences. Six rate cuts in the past 18 months and numerous tweaks to reserve requirements have not yet provided the boost Chinese or global markets were seeking. China’s slowdown and corresponding economic measures (Purchasing Managers’ Index, ore imports, etc.) declining was not new in the fourth. During this period, already declining commodity prices were exacerbated by the reported supply metric imbalances. Most notably, OPEC (i.e., Saudi Arabia) effectively declared that maintaining market share a more significant goal than maintaining price targets. The official lifting of international sanctions on Iran after the start of the new year increases the potential supply imbalance.
Interestingly though, over 60% of U.S. dollar (USD) corporate revenue exposure is tied to North America compared to 6% to Asia. Direct exposure to China for overall U.S. credit is minimal, with the exception of the energy and metals & miners sectors, for whom China is considered the marginal consumer. However, the market sentiment and global slowdown narratives pervaded fixed income as an asset class, from Fed considerations to overall credit performance.
A sign of the times
Though as noted previously, exogenous factors such as monetary policy transitions and global concerns have significantly impacted credit performance this year, internal metrics remain important. Credit ratings migration are back underway in the U.S. credit universe. Throughout this period of historically low interest rates, global corporations have opportunistically refinanced their higher cost debt obligations. Additionally, a number of companies have also utilized low-cost financing to affect large transactions including share repurchases and mergers and acquisitions. The result has been a downward migration in credit quality for several large investment grade issuers.
Furthermore, the ratings agency approach to U.S. financial institutions remains an evolving process. The effects of the removal of governmental support elements, which once elevated credit ratings, have been exacerbated by new capital requirements and increased regulatory costs. Taken together, this has had a pronounced effect on the composition of the global investment grade credit market. For example, the Barclays U.S. Long AA Corporate Index, a key benchmark for many liability-driven investors, is comprised of 24.3% Wal-Mart bonds and the top five issuers represent nearly 60% of the total value. Issuer concentration such as this presents significant idiosyncratic risk factors, which must be managed carefully for those adhering to published benchmarks as a means of assessing portfolio risk or discounting their liability curve.
Notably, it has not entirely been downgrades that have resulted in the credit quality migration. While issuers such as AT&T, Verizon and McDonald’s now carry ratings of BBB by at least two agencies, on June 18, 2015, General Motors was upgraded back to investment grade by Fitch, the second agency to do so. We do not see either side of the ratings migration letting up during 2016, therefore we anticipate that broad indices such as the Barclays U.S. Credit index will soon reflect an overall credit quality of Baa1/BBB+, compared to the present rating of A3/A-. In our view, investors who rely too stringently upon ratings agencies to establish credit quality standards are doing so at the expense of increased sector and issuer concentration risk.
As we look back at the year that was, it is hard to reconcile the moderate U.S. growth, reasonable corporate profits, low inflation and accommodative monetary policy to the poor performance of credit, without considering the fears surrounding China and the Fed’s transition. While these two factors distorted returns for 2015, they have created significant opportunities at both the sector and security level within investment grade credit. On a historical basis, U.S. corporate spreads (relative to U.S. treasuries) are well above median (180 vs. 110 bps) and average (180 vs. 130 bps). In particular, option-adjusted spreads on long corporates (250 bps) are nearing the extremes reached only during three stressed periods in the past 15 years: recession of 2002, Eurozone crisis of 2011-12 and of course the much wider spreads of 2008-09.
Further, valuations for many credit segments match only those experienced during a few brief periods in much more stressed macroeconomic environments in the past two decades. Stable, albeit slow U.S. growth and compelling supply/demand dynamics for USD credit help underpin the investment case for the sector.
Despite recent increase in China fears, which will take time for the market to digest and process, Fed clarity on policy will remove at least one uncertainty that had weighed on markets in 2015. With the U.S. poised to be the growth leader among developed nations in the upcoming year as well as continuing to serve as the safe harbor against global uncertainty, while still offering relatively higher yields, the foundation for U.S. fixed income remains strong.
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