October 2014

As we wrote last month, illiquidity and investor nervousness wreaked havoc on the junk bond market as investors attempted, en masse, to liquidate their junk holdings. That nervousness carried over into the broad capital markets in October in trading that was reminiscent of October 2008.  The economy is clearly on solid footing and the necessity of a zero interest policy has long passed. Nonetheless, we expect that our perseverance will soon be rewarded as interest rates normalize.

During the month, a confluence of factors prompted traders to hit the panic button and shed risky assets, beginning with Bill Gross’ sudden departure from PIMCO. News crossed that nervous investors were liquidating their PIMCO holdings and that selling widened credit spreads marginally as dealers were reluctant to take the other side of the selling. Continuing economic malaise in Europe and the possibility that it would drag export stalwart Germany into recession also weighed on the collective psyche of the market. Adding to the dissonance, debate abounded about whether the falling price of crude oil since early summer reflected weakness in global growth (bad news) or the growing influence of North American production on energy supply (good news). Those fundamentals were more than enough to pressure stock prices, but when news broke that the deadly and presumed incurable Ebola disease reached the United States, near panic ensued. With media coverage bordering on hysteria, fear grew that a pandemic would develop and healthcare officials were helpless to prevent it. Investors began to calculate the impact to profits if people were afraid to congregate or to travel by train, plane, or ship and concluded that the downside could be substantial. The selling was steepest on October 15^th when the S&P 500 had a month-to-date loss of 7.7% and the 30-year U.S. Treasury bond had an intraday high that was nearly six points higher than the opening price. The panic was exacerbated by news that primary dealers of U.S. government bonds turned off their electronic execution systems to avoid selling bonds in a rapidly rising price environment. The panic was halted in its tracks by St. Louis Federal Reserve President James Bullard. While generally considered hawkish on monetary policy, Bullard said in an interview that the Fed could consider postponing the end of quantitative easing given weakness in the markets and the failure of inflation to rise above 2%. Traders took that to mean that the Fed would consider a continuation of their easy money policy and, at the very least, delay the commencement of a rate hike. Stocks rallied sharply as the panic began to subside. Further calming the markets was news that the early Ebola victims had been cured and were back to living a healthy life. The return of greed was so swift and complete that the stock market barely flinched when the Federal Open Market Committee delivered a more hawkish assessment of the economy than was expected at the conclusion of the October 29^th meeting.

However, the most shocking news of the month came early Halloween morning, as the Bank of Japan (BOJ) announced that they would expand quantitative easing from approximately $570 billion to $700 billion a year, in Yen terms. Moreover the BOJ stated that most of the increase in newly printed Yen would be used to purchase Japanese Government Bonds (JGB) and the target duration of the purchases would be increased to 10 years from the current 7 years target. In addition to JGB’s, the BOJ announced that it would increase its purchase of exchange traded equity funds and Japanese real estate investment trusts. Simultaneously, the Japanese Government Pension Investment Fund (GPIF) announced changes to its asset allocation. Specifically, the $1.25 trillion GPIF announced that they intended to increase their domestic equity allocation to 25% from 12%; the non-Japanese equity allocation to 25% from 12%; the Non-Japan fixed income allocation to 15% from 11%; a reduction of the domestic government bond allocation to 35% from 60%; and the cash allocation to 0% from 5%. In working through the arithmetic, the fund will be upping their domestic and international equity allocations by approximately $165 billion each and reducing their holdings of JGB’s by a whopping $317 billion. Equity markets around the globe spiked higher on the news as investors sought to buy equities before the Japanese government executed their orders. In our opinion, this is clearly a “Hail Mary” attempt to sharply devalue the Yen and improve the Japanese export sector and not a “new policy asset mix…compatible with the changes in long-term economic prospects” as it was described in the GPIF press release. BOJ Chairman Kuroda cited the falling price of oil as a factor in the policy moves. His rationale, which strikes us as deeply flawed, is that the drop in oil prices will result in an unwanted fall in CPI, which will have a psychologically negative effect on retail spending. Seemingly, Kuroda believes that the added discretionary income coming from falling energy expenditures will be saved not spent, but if the consumer price index is rising, consumers will be more eager to spend. Hence a weaker yen will offset that falling price of oil in the inflation calculation and make Japanese goods cheaper on the world market. We believe he is likely to get his wish for a weaker currency, even from the recent highs, but fear that the rising cost of crude oil, Japan’s largest import, will sap the spending power of its citizens which, in turn, will result in even less consumption. In that, we see the move as a risky one for the Japanese.

The bond market staged a strong rally in the liquidity-starved month of August as professional traders and arbitrageurs squeezed shorts, pushing bond prices higher and the yield curve flatter.  The rally came despite continued economic strength and was accomplished in conjunction with a rally in equity prices.  Typically, bond and stock prices move in the opposite direction, but in August, the yield-to-maturity of the 30-year Treasury bond fell 24 basis points while the S&P 500 generated a total return of 1.92%.

While trading activity in the investment grade bond market was rather pedestrian during August, the high yield market suffered through a mini-crisis.  The sometimes nasty risk reward relationship present in the search for yield in a zero interest rate world was evident in the Junk bond market during the last week of July and the first week of August.  The outflows began in June with a modest $1 billion outflow followed by a more material outflow of $5 Billion in July, and the exodus intensified during first four trading days of August, with redemptions totaling more than $7 Billion.  The catalyst could be blamed on geopolitical factors, including the ongoing wars in various parts of the world, and/or the ongoing economic weakness in Europe.  However, just as likely, the motivation was investors locking in profit.  In this low-volatility, Fed-engineered market, investors are easily lulled into the comfort of the status quo and to intrepidly add risk in search of yield.  That state of bliss is occasionally disrupted by the sobering realization that with more yield comes more risk.  At the end of the day, the junk bond market had just gotten too expensive and when investors attempted to sell, the street was in no mood to buy.  What started as a price weakness quickly devolved into a rout.  Since bottoming in early August and retracing 75% of the move, junk bond prices are now trading at the mid-point between the recent high and recent low, with the nervous retail investor eyeing the exit and opportunistic institutional investors hoping the market holds.  While we like a select number of high yield names, we think the category is expensive and vulnerable to lack of liquidity “herd” selling that was witnessed mid-summer.

At the time of this writing, the Employment report for August has just been released and the results were marginally disappointing, registering a net gain of 142,000.  While below the 12-month moving average of 206,000, the job gain was enough to lower the unemployment rate to a cycle low of 6.1%.  It’s been a monthly routine for economists to downplay the robust employment reports witnessed over the last year, namely because the labor force participation rate has fallen from approximately 66% of the population prior to the crisis to 62.8% as of last month.  Pundits have pointed to the lower participation rate as evidence that the economy has not fully “healed” and that the Fed should continue with their extraordinary easing measures.  That opinion was refuted this week by the Federal Reserve Bank of Cleveland’s research department in a paper titled “Labor Force Participation: Recent Developments and Future Prospects.” In it they present the case that the fall in participation is attributable to the aging baby boomers leaving the workforce.  Moreover, the paper argues that the participation rate is likely to fall even as the economy continues to grow, as the younger boomers join their older cohorts in retirement.  If the research is correct, a worker bottleneck may be closer than the FOMC has handicapped.  If so, we could be on the verge of a corresponding pick up in wage growth.  Such a pickup is already underway in the construction and home improvement industries.

June 2014

Bond market performance in June was lackluster as rates were essentially unchanged for the month.

For those espousing the fragility of the economic recovery and supportive of continued emergency monetary policy, the June employment report must have been a shocker.  That constituency is dwindling given the continued robustness of job growth.  As was reported earlier this month, the economy added 288,000 jobs in June, the fifth consecutive monthly gain in excess of 200,000.  Moreover, the twelve and twenty-four month average monthly gain of new jobs is more than 200,000.  Of those 200,000, 100% represented net new job entrants as the labor force has essentially remained unchanged over the last two years.  With that, the 2.4 million new jobs added annually has directly impacted the unemployment rate, which is borne out by the drop in the rate from 8.2% on June 2012 to 6.1% as of last month.  Should the economy continue to add 200,000 a month for the next year and the labor force remains unchanged, the unemployment rate will fall to 4.5% by next June.  That level would approximate the lowest rate in two decades.  A continued fall in unemployment is likely to translate into stronger economic growth as the newly employed spend their wages on essential and discretionary items.  Similarly, as the unemployment rate falls and the pool of available workers shrinks, workers are better positioned to demand above average wage increases.  Economic theory holds that such a condition would result in demand pull inflation as a heightened level of money chases a steady supply of goods.  That condition could be exacerbated by the massive supply of money engineered by the Federal Reserve.

Just as evidence of the shrinking pool of available workers can be found in the unemployment rate, the lesser followed Job Openings and Labor Turnover Survey (JOLTS) report has steadily risen since bottoming in 2009 and now indicates that as of May, there are 4.6 million job openings in the United States.  Tech companies are struggling to fill highly skilled engineering jobs and say that it can take up to four times as long to fill a skilled engineering job versus the time it takes to fill a non-technical position.

In addition to employment, manufacturing, as measured by the purchasing managers index, continues to expand at a robust pace.   Similarly, the pace of new home sales rebounded smartly in May, selling at an annualized pace of more the 500,000.  Also during the month, it was reported that the Consumer Price Index rose 2.1% year-over-year, crossing the 2.0% threshold targeted by the Federal Reserve.  If only the actual rate of inflation was 2.1%.  In an informal survey of clients and colleagues, not a single person thought that their cost of living was 2.1% or lower than the same level last year.

Taken in aggregate, one would think that robust job growth, healthy manufacturing growth, improved home sales, and rising inflation would be enough to prompt the Federal Reserve policymakers to end their emergency monetary policy immediately.  Instead, Chair Yellen has communicated that the pace of quantitative easing will continue to be tapered until it ultimately concludes this fall, and has assured the public that the first hike is still some time off.  We continue to believe that this is a serious policy mistake.  Conventional knowledge holds that a change in monetary policy takes twelve to eighteen months to affect the economy.  If, as outlined above, the unemployment rate falls below 5.0% by next year the Fed will find itself well behind the curve and will need to act more aggressively when it ultimately decides to raise interest rates.

April 2014

Investors pushed bond prices marginally higher in April with the yield-to-maturity of the 10-year Treasury falling 6 basis points, and the 2-year Treasury essentially unchanged for the month.

Any suspicion that the economic slowdown witnessed earlier this year was anything more than weather-related was dispelled with the release of the employment report for April.  Recall that investors were surprised last month when the March employment report showed a gain of 192,000 workers.  Worried that the sizable increase in workers didn’t jibe with the anecdotal slowdown in economic activity, many expected that the report would be revised lower.  In fact, the opposite occurred.  The Bureau of Labor Statistics reported that 288,000 jobs were created in the April and the March report was revised by 11,000 to 203,000.  That marks the third consecutive month that the U.S. economy has generated more that 200,000 new jobs.  That news comes on the back of better than expected corporate earnings.  At the time of this writing, both revenue and earnings for the first quarter are exceeding estimates, shaking off the weather-related drag.  The equity market has struggled to rally, though, as corporate management has guided expectations for future growth lower.  With that warning, investors are left to grapple with whether record profit margins are sustainable and pent-up demand from the winter will translate into greater revenue for the remainder of the year, or have margins peaked and corporations may begin to see rates of profitability slow.  Complicating the matter is the anecdotal slowdown that has been evident in the housing sector.  While housing demand was quite likely impacted by the bad weather, it’s nonetheless, being watched as an indicator of economic health.  Also weighing on the minds of investors is Russia’s uninvited intrusion in the Ukraine and the implications former Soviet Union members.

In an interesting turn of irony, Apple announced an $11 billion multi-tranche corporate deal on April 30th, 364 days after they brought their last mega-deal to the market.  The deal issued last year totaled $17 billion, which represented the largest corporate bond deal to date at the time.  Like last year’s deal, the new Apple bonds were spread among maturities ranging from 3-year notes to 30-year bonds.  To recap, the 30-year tranche issued last year was initially priced at a spread of 100 basis points more than the Treasury note of the same maturity.  That deal traded above par for exactly four days and hasn’t closed above since issuance.  Spread widening and rising interest rates pushed the dollar price of the issue to a low price of $81 last fall before recovering to the low $90’s recently.  In marketing the new issue, dealers suggested the spread would be as wide as 120 basis points more than the yield on 30-year Treasury bonds.  But with demand strong, the spread was narrowed by 20 basis points to the identical 100 basis points at which the 2013 issue was priced.  The change in that spread represented approximately a 3% premium for the buyers of the new debt.  Portfolio managers that bought the issue should hope that history doesn’t repeat itself because the 2013 vintage closed its first month of trading down 9% on heavy volume.

February 2014

Unlike the wild swings witnessed in January, capital markets were relatively calm in February with the yield of the 10-year and 30-year Treasury securities effectively unchanged for the month.  Similarly, equities reversed the selloff suffered in January and early February, ultimately posting a year to date total return of 0.94% through the end of the month.

On February 19^th, the Federal Reserve released the minutes of the January Federal Open Market Committee meeting, the first Chaired by Janet Yellen.  While the Fed had repeatedly communicated that there would be continuity in monetary policy as the Chairmanship was passed from Bernanke to Yellen, the minutes reflected otherwise.  Attention had been focused on whether or not the committee would continue to reduce the pace of quantitative easing.  As we wrote last month, the economy has been sputtering through a weather-related slowdown and there was some speculation that the Fed would suspend the pace of tapering in an effort to offset the slowdown.  For the record, we did not share that opinion.  In reducing the pace of quantitative easing, the Fed is only doing less emergency easing; in no way are they tightening policy.  Surprisingly, the discussion among the policy makers was more hawkish than we had expected.  What caught our eye was the statement “downside risks to the forecast were thought to have diminished, but the risks were tilted a little to the downside because with target Fed Funds at its lower bound, the economy was not well balanced to withstand future adverse shocks.”  In other words, the Fed realizes that they don’t have much “dry powder” stimulus should an unanticipated shock disrupt economic growth.  This has been a worry of ours for some time.  When questioned about that risk, Fed policy makers have said that increased quantitative easing would mitigate such a risk.  Nevertheless, they’ve been reluctant to admit that they no longer have interest rate management as a policy tool.  Apparently the discussion delved far deeper into the question of interest rate normalcy.  The minutes indicated that three of the Regional Presidents of the Federal Reserve were in favor of raising the Fed Funds rate “relatively soon” and specified that by targeting this summer.  That’s certainly a departure from keeping rates low for an extended period of time.  The shift in discussion could become more pronounced when Stanley Fischer, the Vice-Chairman nominee joins the Fed.  Fischer has advocated a more reactionary monetary policy both while at the Bank of Israel and in comments since leaving that post.  Under his supervision, the Bank of Israel was the first Central Bank to raise rates following the financial crisis.  Recently, there has been a divide between several of the more hawkish bank Presidents and the decidedly more dovish Fed Governors.  Should Mr. Fischer advocate a more balanced approach to monetary policy, the message from the Fed could soon be one of restraint.

Interestingly, despite the Fed comments, investor appetite for risk has increased.  Since the beginning of the year, the spread of investment grade corporate and municipal debt has narrowed versus U.S. Treasury notes of similar maturities.  Similarly, the S&P 500 has rallied nearly 7% to 1859, a new record high since closing at 1741 on the first trading day of February 2014.  One would assume that the members of the FOMC are watching the heightened risk appetite and factoring it into their thoughts on interest rate policy, which is what prompted the change in discussion at the last meeting.