2013 midyear outlook: Time to change your focus?
James Kochan, Chief Fixed-Income Strategist
The fundamentals that typically determine the behavior of interest rates continue to suggest that it is too early to abandon the bond market strategies that have been successful over the past four years. Investing for income rather than safety is, in our view, still the preferred strategy. July 1 marks the start of the fifth year of this cyclical recovery. It is unprecedented in the postwar era for interest rates to be at cycle lows this late in the recovery and expansion phase of the business cycle. This, however, is an unusual expansion— so unusual that interest rates could stay exceptionally low for another 12 months or longer. Economic developments that, in the past, have signaled the onset of a cyclical rise in rates are still not evident.
Economic growth in the U.S. and around the world is much slower than in past cycles. In the U.S., real GDP growth has averaged 2% over the past 16 quarters, or approximately one-half the average growth rates of previous expansions. Most forecasts predict only slightly better growth over the next 12 months. The economies of Europe are in recession, Japan is growing slowly, and growth in China and India is significantly slower than it was a year ago. Relatively anemic growth does not typically produce interest-rate pressures.
Inflation pressures are also largely absent, and leading indicators of inflation are not threatening. Unit labor costs are increasing at only a 1.1% annual rate. By comparison, in the periods of rising inflation in the 1970s, those costs increased at an average annual rate of 5%, with some years showing doubledigit increases. Growth in the money supply is also relatively subdued. The M2 version (a definition of money supply that serves as a key economic indicator for forecasting inflation) has increased only 7% over the past 12 months and is at a low 3% annual rate thus far in 2013. In contrast, double-digit growth rates in M2 were the norm when inflation was severe in the 1970s and 1980s. Recent weakness in the world commodity markets also suggests that inflation could remain subdued.
An exceptionally weak recovery in private-sector borrowing is another factor limiting interest-rate pressures. The latest Fed data shows that borrowing by households and businesses was increasing at less than a 1% annual rate in the first quarter of 2013. In the five years before the 2008 to 2009 recession, that growth was in the double digits. Again last quarter, households retired more debt than they added. The amount of mortgage debt outstanding has declined every year from 2008 through 2012—an unprecedented development. In the first quarter of 2013, mortgage debt outstanding decreased again, at a $200 billion annual rate.
Even including the federal government, total borrowing in the U.S. capital markets is growing at a low 4.5% rate. In the periods of high inflation and high interest rates in the1970s and1980s, those growth rates were in the double digits. In the years 2003 through 2007, annual growth in total borrowing stayed in the 8% to 9% range. A weak pace of borrowing helps explain why money supply growth has been moderate, despite the exceptional creation of bank reserves by the Fed.
Fed policy is also unlikely to push rates permanently higher in the months ahead, despite considerable discussion concerning when the Fed might begin to reduce its monthly purchases of Treasuries and mortgage-backed securities (MBS). The majority of the FOMC members apparently need to see strong and sustainable economic growth before they would consider reductions to the purchase program, and those criteria are not yet in sight. Moreover, Chairman Bernanke has explained that the federal funds rate is likely to remain near zero—even after the monthly purchases end. Thus, the onset of a cyclical rise in short-term rates might be more than 12 months away.
The May correctionThe market correction this past May and June was a reminder that while the Fed can control shortterm rates, it has limited influence on bond yields. Fears of a reduction in Fed bond purchases, plus a few stronger economic indicators, were sufficient to cause note and bond yields to increase as much as 50 basis points (bps; 100 bps equals 1.00%) in May. The consequent price declines pulled year-to-date total returns into negative territory in all but two sectors—corporate high yield and municipals. It is understandable that such a severe correction would spark fears of a cyclical bear market in bonds. If, however, the discussion of market fundamentals presented here is correct, this was probably a onetime adjustment to more realistic yield levels, especially in Treasuries and markets in which spreads to Treasuries were narrow or no more than average.
In the Treasury, investment-grade corporate, and municipal markets, yields have moved back to the levels that prevailed prior to the flight-to-safety rallies in the spring of 2012. The European financial crisis that began in March and April 2012 sparked a huge rally in Treasuries and, subsequently, in the rest of the U.S. bond markets. Demand from overseas investors frightened by events in Europe or elsewhere was largely responsible for the historically low yields of last summer and fall. With the overseas markets relatively calm in recent months, demand has weakened and U.S. yields have increased. But with Treasury borrowing falling off somewhat and weak private-sector borrowing, a weaker foreign bid need not propel yields beyond levels that persisted before the European crisis.
Strategy recommendationsThe May and June correction was also a reminder that, consistent with investors’ experience of the past 12 months, investing for interest income rather than potential price appreciation will likely be the better strategy over the next six to 12 months. The total returns shown in Chart 2 highlight the poor returns of the lowest-yielding sectors. The returns from corporate high yield clearly included some price appreciation, but most of that occurred during the final six months of 2012. Treasury returns clearly included price depreciation, with much of that occurring in May.
If, as we expect, total returns from fixed income in the next six to 12 months reflect primarily interest income, investors should stay with strategies that were successful over the past 12 months. We would expect returns from Treasuries and Treasury Inflation-Protected Securities (TIPS) to be positive but relatively meager and returns from MBS to be only marginally better. We believe that spread sectors— specifically the corporate and municipal markets—continue to offer the better relative values.
Even after producing exceptional returns over the past four years, we believe the high-yield corporate bond market still offers the best values among the domestic taxable sectors. While yield levels are near record lows, yield spreads to Treasuries remain approximately 100 bps wider than those that prevailed from 2004 into 2007. For example, the current yield spread between a typical 10-year B-rated corporate and the 10-year Treasury bill is approximately 400 bps. From 2004 to 2006, that spread averaged 350 bps and was frequently as low as 300 bps. These comparisons suggest that the high-yield spreads have room to narrow should Treasury yields rise further and that the high-yield market should continue to record total returns substantially greater than those of the Treasury market.
To be sure, a rally as strong as that of the high-yield market can eventually produce a degree of market frothiness, and the high-yield market is showing a few of these signs. Bond structures that were last seen in 2006 to 2007—such as payment-in-kind options and those without protective covenants— have reappeared in recent months, mostly among the weakest credits. These features favor the issuers, not the investors. To minimize the risks associated with them, a more cautious approach to high yield might now be appropriate. That would include underweighting the weakest credit categories and the longest durations. We would increase allocations to short-term high-yield portfolios that have little or no exposure to the weakest credits. Although a yield penalty is associated with this strategy, a marginal reduction in credit risk is, in our view, a prudent move at this stage of the high-yield cycle.
Because spreads to Treasuries are less generous in the investment-grade corporate market, returns in this sector have been more closely correlated with the Treasury market. Spreads for AA- and A-rated issues are close to the averages seen in 2004 to 2006. In the BBB segment, spreads to Treasuries are approximately 50 bps wider than the averages in 2004 to 2006. These wider spreads have helped the BBBs consistently outperform the higher grades, a pattern that we believe is likely to continue over the next 12 months.
Municipal bonds: Focus on issue selection, not durationThe salient features of the municipal market have been—and still are—generous yields versus Treasuries and unusually wide quality spreads. As a result, municipals have consistently outperformed Treasuries over the past four years and the weaker credits have consistently outperformed the high grades. Much has been made of the fact that yields on most AAA municipal bonds are no longer higher than yields on comparable Treasuries. It should be noted, however, that prior to 2008, AAA municipal bond yields were typically around 0.75 of Treasury yields. Now that ratio is 1.0. For A-rated municipal bonds, the ratios are now as high as 1.5 versus precrisis ratios of around 0.9. By all but the most recent standards, municipal yields remain generous compared with Treasury yields.
Yields in the A and BBB credit segments are a percentage point higher than they are in the AAA and AA segments, which have spreads that are approximately triple what was typical prior to 2008. As a result, over the past four years, a portfolio of A/BBB credits would have outperformed an AAA/AA portfolio by 200 to 300 bps per year. Over the past 12 months, the performance differential was 220 bps. Capturing incremental returns from the weaker grades requires the support of thorough credit research so that a portfolio manager can identify the credit segments to overweight. If market yields are not likely to trend sharply higher or lower over the next six to 12 months, adding incremental income from issue selection rather than by extending duration would be expected, in our opinion, to be the more successful strategy.
International: Developed markets may offer better opportunitiesEmerging markets debt has not performed well thus far in 2013, in part because the dollar has strengthened versus many emerging markets currencies. With growth slowing in many emerging economies, a weaker currency is seen as one way to spark economic activity. Economic concerns are likely to continue to hurt local-currency emerging markets debt performance in the months ahead. Both the local currency and dollar-denominated emerging markets debt might have difficulty matching the performance of domestic high yield during the remainder of 2013.
It might be counterintuitive, but the developed markets now appear to offer somewhat better opportunities than the emerging markets. If the economies of Europe and Japan perform even slightly better in the second half of 2013, corporate credit quality should improve and currencies would not be expected to weaken versus the dollar. Many of the economies of Eastern Europe and Latin America are performing well. After the severe corrections thus far in 2013, these developed markets might now have the potential to outperform U.S. Treasuries and investment-grade corporates.
Conclusion: Investing for income rather than safetyThe poor performance of the domestic and international fixed-income markets in May and June has revived fears of the onset of the dreaded cyclical bear market in bonds. The more-likely scenario, however, is less dramatic. The economic fundamentals that typically govern the behavior of interest rates and bond yields are much the same as they were one or two years ago. Those fundamentals—relatively weak economic growth, low inflation, and a slow pace of private-sector borrowing—have kept short-term rates low and bond yields within relatively narrow ranges over the past two years. Over that period, investing for income rather than safety has been a successful fixed-income strategy. It is our view that staying with that strategy is likely to be the best course over the next 12 months.
The views expressed are as of 6-17-13 and are those of Chief Portfolio Strategist Brian Jacobsen, Chief Equity Strategist John Manley, Chief Fixed-Income Strategist James Kochan, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.