May 2012

May 31, 2012  |   Monthly Commentary   |     |   0 Comment

Risk aversion returned to the capital markets last month, as investors struggled to understand the fate of European monetary union. The fear was most evident in the exodus of Euro-denominated assets out of European banks and into the U.S. dollar. Spanish banks bore the brunt of the capital outflow, with an estimated 100 billion Euros leaving Spain. As a result, the dollar appreciated more than 6.5% versus the Euro during the month. The U.S. bond market benefited directly from that dollar flow, with the yield on 10-year Treasury notes falling to 1.56% from the 1.94% level at which it started the month. The panic was magnified in the stock market as the S&P 500 lost 6% for the month.

Compounding investor worry, the May employment report showed that the U.S. economy added 69,000 jobs during the month, well below the already subdued estimate of 150,000. To be certain, the deceleration in job growth has caught us by surprise. It seems that the ongoing uncertainty surrounding domestic fiscal policy is slowing what was shaping up to be an accelerating recovery. Based upon that assumption, we have downgraded our growth assumption. We started this year with a forecast that 2012 GDP growth would register 2.75% to 3%. It now seems likely that GDP will come in closer to 2.0%. However, while we expected a slower rate of economic growth, we do not believe that the U.S. economy will slip into recession. Despite the downgrade of our growth forecast, our investment thesis has not changed. We deem interest rates to be artificially and significantly depressed and credit to be cheap. Moreover, with the cost to hedge quite low and the payoff ratio so attractive, our short-term interest rate hedge continues to be an integral component of the fund. In addition, we continue to find interesting opportunities in credit, especially in the municipal bond sector.

While May proved to be a difficult month for developed markets, the collateral damage sustained by emerging market investments in both equities and fixed income was even more substantial. The currencies of Brazil and India were down approximately 6% versus the U.S. Dollar, while the Mexican Peso plunged nearly 10% for the month. For equity investors, the loss was exacerbated by stock markets that were down by 4% to 6% for the month. Emerging market investments were the darlings of the brokerage community just a few months back, touted as offering a higher yielding alternative to developed markets with the added benefit of an appreciating currency. As we’ve discussed previously, an unhedged investment in emerging market debt generates fixed income-like return with equity-like risk. In other words, investors are not paid to take on the added risk.

Despite the red ink that flowed in the latter half of May, the month was not devoid of good news. Several measures of housing activity registered better than expected, including surprise increases in housing starts, existing home sales, and new home sales. Also of note, there were several credit positive events during the month, the most significant being the upgrade of Ford Motor to investment grade. Ford has suffered as a sub-investment grade credit since July 2005, which meant that their access to credit markets was limited and their cost of borrowing significantly higher. To celebrate their elevation to investment grade status, the carmaker issued $1.5 Billion in 5-year notes at a spread of 230 basis points above Treasury notes. That’s approximately 100 basis points tighter than where Ford paper traded just six months prior.

Another “fallen angel” returned to the market during the month, much to our surprise. Late in the month AIG came to market with $750 million in 10-year notes at yield spread of 325 basis points above Treasury notes. Surprisingly, since issuance, the paper has appreciated with the spread above treasury notes falling to 304 basis points. We did not participate in the purchase and are not anticipating holding AIG paper any time soon. In purchasing a bond, we need to feel comfortable that the borrower is willing and able to repay the bond at maturity. We’re not comfortable that AIG meets either of those criteria.