Financial anxiety remained elevated during September as evident in the hyper-volatility of the stock market, acute widening in credit spreads, sharp rally in the U.S. Dollar, and the continued flight to U.S. Government debt. Our opinion is that with stability returning to the stock market and bank rumors subsiding, the price of corporate bonds will swing from loss to profit.
A byproduct of the worry was the dramatic, broad-based market downturn in commodity prices, including oil and gold. The logic behind the commodity swoon was, if economic expansion slows, less discretionary income will be available for energy consumption and a corresponding fall-off of inflation would reduce demand for gold. Less apparent during the month was the significant widening in financial credit spreads. On the back of liquidity-related rumors, the yield-to-maturity for high profile names such as Bank of America, Morgan Stanley, and Goldman Sachs rose to more than 5% for maturities of three years and longer. The paradox is that those three names have been specifically identified by the Federal Reserve as entities that are systematically important. Deemed “too big to fail,” those entities are subject to heightened scrutiny from the regulators with the intention of ensuring that failure is not possible. Nevertheless, in reaction to rumors, investors ignored balance sheet fundamentals and, instead, invoked the “sell first, ask questions later” tactic. Exacerbating the price weakness was the lack of secondary demand from Wall Street. A central tenant of Wall Street reform, known as the Volker Rule, is the abolishment of bank-related proprietary trading desks. In theory, the absence of a trading desk reduces the risk to the financial health of the bank due to swings in the market value of the instruments traded. The unintended consequence of closing those desks is heightened volatility. Historically, trading desks have provided liquidity during periods of market stress and, arguably, lessened volatility. Their absence, as witnessed in August and September, directly contributed to the weakness in corporate bond prices. From a trading perspective, we at Halyard view the market inefficiency that tends to result from heightened volatility as an opportunity over the long-term.
A perplexing characteristic of the current state of the economy is continued expansion in Gross Domestic Product despite the naggingly high rate of unemployment. Without a doubt, overall unemployment remains too-high by any standard. A disaggregation of the unemployment statistics yields a surprising outcome. This recession and subsequent expansion has been especially harsh on the lowest income earners and not nearly so for college educated adults. According to the Bureau of Labor statistics, the unemployment rate for adults that dropped out of high school and those with a high school diploma but no college is 14.0% and 9.7%, respectively. Those high school graduates with some college education are unemployed at an 8.4% rate, while the rate for adults with a college education is only 4.2%. At 4.2%, the rate of unemployment among college educated adults, the largest of four categories, has steadily fallen and is now the lowest it’s been in 2 ½ years. Moreover, the category of college educated individuals has grown by 10 million in the last decade, while the category of those not graduating from high school has declined by nearly one million. Because college educated individuals earn significantly more than their less educated counterparts, they have been the driver of economic growth during what has come to be called the jobless recovery. But that’s no solace for the approximately 50 million Americans with no college education, and especially the 5.2 million individuals in that category that are unemployed.
Looking forward, we are cautiously optimistic that the coming holiday selling season will be supportive of job growth and economic expansion. With that view, we have maintained our current position of overweight credit, minimal interest rate sensitivity, and hedged with options on short-term interest rates.