June 2013 – Monthly Commentary
As detailed in the last monthly update, we believe the normalization of interest rates has begun, as the vicious bear market witnessed in May continued into June. During the month, the 10-year note reached a high yield of 2.61% before closing the month at a yield-to-maturity of 2.49%. That’s nearly one hundred basis points higher than the 1.62% low touched in early May. While we have been anticipating rising interest rates and had prepared for such a move with our hedges, we were surprised by the magnitude of the widening in credit spread that occurred during the month. To the contrary, a central tenant of our investment thesis is that as interest rates rise credit spreads will contract to the point that some investment grade corporate issues will trade at a small discount to Treasury paper. The fundamental rationale for that view is that corporate balance sheets are quite strong while the national debt has ballooned, causing an excess supply of Treasury debt. We expect that excess supply will be unmanageable once the Federal Reserve ceases to buy Treasury notes in the secondary market. Counter to that view, in June, corporate and municipal prices fell faster than Treasury notes due to a technical imbalance related to Exchange Traded Fund (ETF) liquidation. The sharp rise in interest rates “spooked” investors, prompting overwhelming selling of fixed income ETF’s. With the elimination of proprietary trading desks as a result of Dodd-Frank legislation, the risk appetite of Wall Street to absorb such selling has been severely reduced. As a result, the number of outstanding shares in several fixed income ETF’s were forced to contract, which resulted in selling of the securities that comprised the ETF. As the ETF selling cascaded and the float contracted, share prices fell to a substantial discount creating a vicious-circle of selling. While the selling imbalance only lasted two days, the impact to the credit market remained through month end, as dealer desks struggled to digest their newly bloated inventory. At the time of this writing, credit spreads have begun to tighten back to their pre-crisis valuations and we expect a full recovery. As such, we are maintaining our current positions and have added exposure in several names.
Turning from trading technical’s to economic fundamentals, the U.S. economy continued to surprise to the upside during the month, led by robust sales of cars, homes, and retail goods. In the housing sector, demand for homes is evident in the rise in prices. As measured by the S&P/Case-Shiller Index of 20 cities, the average home price has risen 12.05% year-on-year. The improving jobs market has been a driver of spending. In the past 12 months, the U.S. economy has added an average of 195,000 jobs per month, with average hourly earnings rising more than 2%. That mix of more people working and wages rising paired with the wealth effect of rising home prices and stock prices provides the foundation for a sustainable economic recovery. From that foundation, we expect that the Federal Reserve will be able to begin “project taper” without severely destabilizing the capital markets or tipping the economy back into recession. However, the path to normalized interest rates is likely to include periods of volatility as investors speculate as to when, and by how much the Fed program is amended. Our expectation is that the Fed will announcement their intention to begin tapering purchases at the press conference following the September 18th FOMC meeting.