Market Perspectives - July 2012
2012 mid-year outlook: Looking past the cliff
Fixed incomeBy James Kochan, Chief Fixed-Income Strategist
Turmoil in Europe, slow U.S. growth, and a cautious Fed all suggest that interest rates and bond yields will not be increasing significantly during the next 12 months. If, however, the European crisis were to ease somewhat, yields on Treasuries could move back to pre-May levels. Consequently, over the near term, a conservative approach to the fixed-income markets might be appropriate.
Long-term fundamentalsThe fundamentals that have governed the bond markets since 2009 are still in place. Chart 4 shows that borrowing in the U.S. capital markets by households and businesses remains weak. Before the financial crisis, private-sector borrowing was increasing at a rate of more than $2 trillion annually, with $1 trillion of that borrowing taking place in the mortgage market. Private-sector net borrowing was negative in 2009 and 2010, as households and businesses paid down, or had written down, more debt than they acquired. In 2011, net borrowing was at a weak $300 billion annual rate, and in the first quarter of this year, that pace of borrowing was only a $500 billion annual rate. In 2011 and in the first quarter of 2012, business borrowing was increasing modestly while household borrowing was still shrinking due to sizable net reductions in mortgage debt. Mortgage debt outstanding has now been declining for the past 16 quarters, a development never seen before in this country. The absence of any meaningful recovery in private demands for borrowed money helps explain why interest rates and market yields have remained exceptionally low this far into a cyclical expansion. Even with the record pace of borrowing by the U.S. Treasury, total borrowing in the capital markets is running more than $500 billion per year below the pace seen between 2004 and 2007.
Chart 4: Borrowing in the U.S. capital markets
As discussed earlier in this report, we expect the U.S. economy to continue to grow at a relatively slow pace and inflation to stay relatively low. In that event, private-sector borrowing should remain weak and Fed policy should remain highly accommodative. The housing sector is a big user of borrowed money, and it is expected to remain weak well into next year. A near-depression in housing has been a source of frustration to Fed officials. Exceptionally low interest rates have not had the desired stimulative impact on the economy, largely because those rates have not sparked a recovery in housing. It is likely, therefore, that the Fed will keep the federal funds rate near zero until it sees meaningful recoveries in home sales and housing starts.
If short-term rates stay near current levels, cash equivalents would be expected to continue to produce exceptionally poor returns. Chart 5 illustrates how costly—in terms of forgone income—it has been to be in cash during the past two and a half years. That pattern of returns—with a few exceptions—is likely to persist for at least another 12 months. The exceptions might be Treasuries, because the crisis in Europe has created major distortions in that market.Chart 5: Total returns (12-31-09 to 6-13-12)
Short-term distortionsAs the crisis in Europe deepened during May, the flight-to-safety bid sent yields on Treasury notes and bonds to record lows—lower than during and immediately after World War II, when the Fed was openly supporting the prices of Treasury bonds. A host of global investors, including central banks, were sellers of euros and buyers of Treasuries in May. Those flows into Treasuries can, however, be transitory. Experience has shown that when the overseas markets recover, some of the flows into Treasuries are reversed and yields tend to rise. For example, as the crisis in Europe eased last September and October, the yield on the 10-year Treasury note rose almost 75 bps. Because that yield is even lower now, the risk of higher yields could be greater.
It has been argued that Treasury yields can stay this low for some time because the crisis in Europe could last a long time. The problem with that argument is that the current situation in Europe is not sustainable. The peripheral countries are suffering a run on their banks, a condition that cannot be allowed to continue if a full-scale banking crisis is to be avoided. At some point, economic and political leaders in Europe and around the world must act to restore confidence in the European banks and debt markets. That was one of the lessons learned in 2008 and 2009, and coordinated, bold initiatives are needed once again. If European leaders are successful in diffusing this latest crisis, the days of record-low Treasury yields are probably numbered.
Strategic implicationsWe believe that Treasuries offer little value at the exceptionally low yields seen in May and June. That market is extremely vulnerable to "good news," such as progress in Europe or better-than-expected U.S. economic data. We would avoid Treasuries until yields return to pre-May levels. The same argument holds for Treasury inflation-protected securities, whose yields are again extremely low and whose durations are extended. They would be expected to suffer negative returns if Treasury yields were to rise. Because the mortgage-backed securities market also moves in step with Treasuries, it could also struggle if Treasuries were to correct. Spreads to Treasuries in the mortgage market are not generous, so that sector is not well protected against a backup in Treasury yields.
One market in which yield spreads to Treasuries are extremely wide is the high-yield corporate market. Because high yield is correlated more closely with the equity market than with the Treasury market, yields rise when equities struggle, as they did in May and June. As a result, spreads to Treasuries are again sufficiently wide to provide this market with a degree of "cushion" against a backup in Treasury yields. There is ample scope for these spreads to narrow, keeping the high-yield market relatively stable even in the event of a sell-off in Treasuries. In our view, the high-yield corporate market has the potential to produce returns in the 6.5%â€“7.5% range over the next 12 months.Chart 6: BB-rated spread to Treasuries gives high-yield corporate debt a cushion against potential increases in Treasury yields1
Yields on municipal bonds are also generous versus Treasury yields. The ratio of yields on 10-year A-rated municipals to 10-year Treasuries, which was usually around 0.90 before the financial crisis, is approximately 2.0 now. Even before adjusting for the tax benefits, yields on good-quality municipals are double those on Treasuries. We focus on the A- and BBB-rated segments of the municipal market because quality spreads remain exceptionally wide. The current 100-bp spread between the typical A-rated and AAA-rated 10-year municipal is triple the spread that typically prevailed prior to 2008. Because of these wide spreads over the past two years, total returns on a portfolio of A/BBB credits would have outperformed a portfolio of AAA/AA credits by approximately 300 bps per year. We expect that pattern of returns to persist in the months ahead.
With yields at or close to record lows, accepting credit risk in a municipal portfolio is, in our view, a better strategy than incurring substantial duration risk. In other words, we are more comfortable with intermediate portfolios that are overweight A/BBB credits than long-duration portfolios that have a market weighting in AAA/AA credits. In theory, extremely generous municipal-to-Treasury yield ratios should allow the municipal market to withstand even a significant rise in Treasury yields. In the long run, that has been true. In the short run, however, a serious correction in the Treasury market usually sparks a smaller, but significant, rise in municipal yields. That is why we are now slightly more cautious in our tactical approach to the municipal market. Should yields return to pre-May levels, approximately 50 bps higher than mid-June levels, we would again be more positive toward longer-duration, medium-quality municipal portfolio strategies.
For almost three years now, cash hasn't delivered much of a return for fixed-income investors. Virtually every segment of the bond market has produced total returns far greater than returns from cash equivalents. We have been arguing that investing for income, not safety, is the preferred strategy. Now, however, with most market yields at exceptionally low levels, a greater degree of caution toward fixed income might be appropriate. Cash equivalents will, in our opinion, continue to perform poorly, so shifts into cash should be tactical, not strategic. A focus on short-duration investments would be preferable to building cash positions. With a short-duration strategy, the investor earns a moderate amount of interest income, versus none from cash, while materially reducing the market risk at a time when the degree of market risk has become somewhat elevated.