Despite the ongoing effort of the Federal Reserve to manipulate bond prices higher, the market experienced a mild bear market in January. For the month, the price of the benchmark 30-year Treasury note fell more than 4% as investors reallocated money out of bonds and into stocks. The selling was disproportionately focused on maturities of 5-years and longer as the Fed continued to espouse its “low rates for a long time” mantra.
Despite the correction in Treasury notes, high yield bonds bucked the trend and rallied in tandem with the stock market, which saw the S&P 500 jump more than 5% for the month. The underlying theme driving rates and equities was a heightened appetite for risky assets. The rationale being, with excess cash on the sidelines and Treasury notes yielding next to nothing, investors “need” to take more risk to generate return. That translated into demand for high yield bonds and dividend paying stocks. Our worry, especially with high yield bonds, is that the additional yield is not nearly enough to compensate investors for the additional risk. At month end, the Barclays High Yield Index offered a yield-to-maturity of 6.61%, 470 basis points more than the Aggregate index. Both on an absolute and spread basis, that’s expensive! Moreover, as money pours into High Yield ETF’s, liquidity risk is growing. As we’ve discussed on several occasions, the structure of an ETF has the potential to destabilize markets should investors rush to sell. One way to measure market liquidity is to divide the market capitalization by average daily volume, which yields the average number of days to turnover the index. A higher turnover rate is indicative of a more liquid market. The two largest high yield ETF’s manage a combined $27 billion in assets, representing 468 million shares, with daily volume for the two totaling 9 million shares, or 1.9% of total shares outstanding. By comparison, 7.5% of the market capital of the S&P 500 changes hands on a daily basis. Based on those statistics, the S&P turns over every 13.3 days, while the two largest high yield funds turnover every 52 days. To further the point, the constituents in the S&P 500 are widely followed, actively traded companies. The same can’t be said of a number of bonds in the high yield ETF. The conclusion, as we see it, is that should an event “spook” investors, the rush for the exit is likely to worsen the selloff.
With a budget deal still elusive, the automatic budget cuts scheduled for March 1st pose a near-term risk to the market. If a compromise is not reached, we expect bond prices to rise in anticipation of a slowing economy and prolonged Fed easing. However, longer term, the performance of the bond market is not so clear. If the sequester tips the economy back into recession, bond prices are likely to go higher as the Fed continues to print money. On the other hand, if the economy has enough momentum to offset the impact of the sequester, the Fed would likely reduce or suspend bond purchases earlier than expected, causing rates to rise. At the time of this writing, investors seem to be handicapping the latter as the most likely outcome.
Economic data for the month continued to portray the economy as growing at a moderate pace, with department stores registering much better than expected sales, while employment continued to expand at a disappointingly modest pace. However, one bright spot in the employment situation is manufacturing employment. In the current decade, manufacturing employment has grown at an average of 13,000 a month with 86% of months showing positive growth. Over the course of the last three years, the economy has added 479,000 manufacturing jobs. That’s far better than the previous decade in which outsourcing sent nearly six million manufacturing jobs overseas. For that period, manufacturing employment contracted an average of 48,000 jobs per month, with only 15% of the monthly surveys showing job gains. It’s clear that the U.S. is enjoying a manufacturing renaissance.