2013 outlook: Love risk by managing it
James Kochan, Chief Fixed-Income Strategist
With yields in most sectors of the domestic bond market at or near all-time lows, it might seem inappropriate to argue that it is still too early in this cycle for fixed-income investors to be overweight cash and cash equivalents. But that has been our strategic advice since 2010, and it remains our strategic position for 2013. We are now in the fourth year of the expansion phase of this business cycle. By this time in previous cycles, interest rates were rising and bonds were performing relatively poorly. This cycle, however, is sufficiently atypical as defensive strategies that were appropriate by now in earlier cycles are probably not the best strategies for the year ahead. In support of that view, we briefly review key fundamentals that influence the behavior of interest rates and then discuss those markets that we expect will produce better returns than cash equivalents in 2013.
Slow economic growthIn mid-2013, this cyclical recovery will be four years old. By this time in the prior six business cycles, real GDP had increased, on average, 18% from the level at the beginning of the recovery. Assuming moderate growth of 2% over the next six months, by mid-2013 real GDP will have advanced 8% from its mid-2009 level. In other words, GDP growth in this recovery cycle is less than one-half the average of the prior six cycles. This is a crucial difference. By the fourth year of those previous cycles, relatively strong growth had begun to produce bottlenecks in the economy that, in turn, produced an increase in wage pressures and inflation. These developments mandated a shift toward restraint by the Fed, which sent interest rates trending upward. With growth so much slower in this cycle, none of those problems have emerged or are on the horizon for 2013.
In Europe and Japan, growth is even weaker than in the U.S. Most countries in the eurozone are in recessions or are growing slowly. Growth in Japan is expected to be around 1% in 2013. The rest of Asia is healthier but is growing appreciably slower than in the past five years. Relatively anemic growth in global GDP is a key fundamental that suggests interest rates will stay low over the next 12 months.
Low inflationForecasts of substantially higher inflation have been highlighted in the media since 2009 because, in their words, “the Fed has been printing so much money.” In fact, the rate of inflation has remained around 2% when measured by the Consumer Price Index and even less when measured by the personal consumption price indexes (the inflation measures preferred by Fed officials). Moreover, leading indicators of inflation are still not robust. The Fed has not been printing lots of money. Growth in the M2 version of the money supply is running at approximately a 7% annual rate. In the 1970s when monetary policy was (in hindsight) too stimulative, M2 growth was well into the double digits.
Labor costs, another important leading indicator of inflation, were increasing at close to double-digit rates in the 1970s. On average, by this stage of the earlier six recoveries, unit labor costs had increased almost 8% from the start of the recovery. Today, unit labor costs are only 1% higher than four years ago. Over the past 12 months, those costs have increased only 0.1%. Intense international competition prevents companies from raising the prices of their goods and services and, in turn, forces them to keep costs under control.
Accommodative monetary policyFed officials have been frustrated by the slow pace of growth and the persistently high unemployment rate during this recovery. The FOMC recently announced its plan to keep short-term rates near zero until the unemployment rate falls below 6.5%. Most members of the FOMC expect that it will be sometime in 2015 before that objective is met. While no one can predict with certainty the future path of growth, employment, or inflation, it is probably reasonable to assume that the Fed will keep the fed funds rate near zero and will remain a significant buyer of Treasuries and MBS through 2013.
The slow pace of borrowingAnother defining feature of this cycle is the collapse in borrowing in the private sector of the U.S. economy. Borrowing by households and businesses was increasing at a $2 trillion annual rate in 2006 and 2007. By 2009, private-sector borrowing had plummeted to -$500 billion—a net decline of an astounding $2.5 trillion. Of that $2 trillion per year of net borrowing, $1 trillion was borrowing in the mortgage market. Since 2007, however, the amount of mortgage debt outstanding has been shrinking—a net decline in mortgage borrowing of more than $1 trillion per year. Housing is a big user of borrowed money, and that sector is only now starting a slow recovery. Business borrowing has recovered somewhat since the recession, but it is still only one-half the prerecession pace. Chart 2 shows that total private-sector borrowing is growing at less than one-fourth the pace seen in 2006–2007, a major reason why interest rates have stayed exceptionally low for such a long time in this cycle.
Chart 2: Borrowing in the U.S. capital markets
Source: Flow of Funds, Federal Reserve
To be sure, the U.S. Treasury has partially filled the void created by the collapse in private-sector borrowing. Treasury borrowing spiked from $235 billion in 2007 to more than $1 trillion per year since then. At the same time, however, purchases of Treasuries by foreign investors have increased sharply. Since 2008, purchases of Treasuries by foreign investors—mostly central banks—have equaled one-half the net amounts issued by the Treasury. In other words, foreign investors have, on average, financed half the federal deficit and thereby helped keep Treasury yields exceptionally low.
In total, these market fundamentals strongly suggest that short-term interest rates will stay near zero for at least another year. In that event, returns from cash and cash equivalents could also be close to zero. While the pattern of returns shown in the bar chart might not be fully repeated in 2013, the poor performance of cash equivalents probably will be repeated. Over the next 12 months, we think income, rather than safety, should be the objective of fixed-income investors.
Chart 3: Fixed-income cumulative total returns, 12-31-09 to 12-18-12
StrategyFinding income in the current market environment is a challenge. Treasury yields remain exceptionally low—well below the rate of inflation for most maturities. Those sectors most closely linked to Treasuries, such as agency notes and Treasury Inflation-Protected Securities, also offer low yields and, in our opinion, little value. Even MBS now offer little value. Spreads to Treasuries for agency-backed MBS collapsed when the Fed announced it would buy $40 billion per month. Those spreads are now only 50–60 basis points (bps; 100 bps equals 1.00%), less than one-half the long-term averages. As a result, the agency-guaranteed MBS market has no ability to withstand a rise in Treasury yields. Should Treasury yields rise even moderately, mortgages would be expected to increase apace and record negative returns.
CorporatesInvestment-grade corporate bonds offer spreads to Treasuries that are close to long-term averages, except for bank-issued paper where spreads are still approximately 25 bps wider than precrisis averages. If Treasury yields remain within the ranges seen in 2012, total returns from investment-grade corporates could be expected to be in the 3%–5% range in 2013. We believe that high-yield corporates offer better values than the investment-grade sector. The highyield market has produced an average annual total return of 11% over the past three years. As a result of this substantial rally, yields in many segments of this market are at or near all-time lows. To some observers, this is a warning that investors should avoid the high-yield market. We disagree because relatively generous spreads to Treasuries should allow this market to produce coupon-like returns in 2013, even if Treasury yields were to rise somewhat.
The chart shows the spread between yields on 10-year BB-rated corporate notes and 10-year Treasury notes. At around 350 bps, the current spread is 30 bps below the 10-year average. If, however, the exceptional spreads of 2008 are excluded, the long-term average drops to 285 bps. Moreover, this spread has stayed as low as 200 bps for extended periods in the 1990s and from 2004 through most of 2007. Thus, even the most conservative segments of the high-yield market still have, in our view, considerable protection from a rise in Treasury yields.
Chart 4: Spread of 10-year BB-rated corporate bond vs. 10-year Treasury
We focus on the BB-rated spreads in part because we want to emphasize the stronger credits within the high-yield market. Market rallies such as we have seen over the past four years tend to be led by the weakest credits. Eventually, those segments of the market become somewhat overvalued. Recently, some signs of that condition have emerged among the CCC and weaker credits. We believe, therefore, that a slightly more cautious approach to high yield is appropriate for the year ahead. In a bond portfolio, we would underweight the weaker credits and the longer-duration issues. We would increase our allocation to short-term high-yield portfolios. Over the next 12 months, total returns might be in the 5%–6% range for a conservatively structured bond portfolio and in the 2%–4% range for a short-term portfolio.
MunicipalsThe municipal market has also produced exceptional total returns over the past four years, and that rally has pulled yields to the lowest levels since the 1950s. The prospect of higher marginal income tax rates and higher taxes on dividends and capital gains combined with relatively light new-issue calendars could sustain a strong demand for municipals despite the low yields. Even at current tax rates, after-tax returns from municipals are well above those from most Treasuries and even most investment-grade corporate notes and bonds. Investors need not be in the highest marginal tax brackets to benefit from the tax-exempt feature of municipals.
Even as yields declined over the past four years, the municipal yield curves have remained relatively steep and credit-quality spreads have remained unusually wide. As a result, intermediate and longer maturities have significantly outperformed shorter maturities, and A/BBB credits have significantly outperformed AAA/AA credits. For 2012, a portfolio of A/BBB credits will have produced a total return approximately 400 bps greater than a portfolio of AAA/AA credits.
Long-duration portfolios have significantly outperformed intermediate-duration portfolios over the past four years. In 2013, however, because of the relatively low yield levels and wide credit-quality spreads, issue selection rather than duration strategy will likely be the major contributor to total returns. In almost every segment of the municipal market, prices have risen to, or near, call prices, thereby severely limiting the ability of a portfolio manager to achieve additional price appreciation. Market corrections, however, could result in price declines. These asymmetrical market fundamentals suggest a risk/reward tradeoff that does not favor long-duration strategies. Incremental returns are more likely to result from employing credit research in the A, BBB, and BB credit categories than in maintaining long durations.
Over the past four years, the municipal market has averaged a total return of 9.2% per year, an astounding record. Almost one-half of that return was due to price appreciation. If additional price appreciation is unlikely in 2013, coupon income will provide almost all of the total return. For portfolios weighted primarily toward the A/BBB credits, returns could be in the 3%–4% range. These credit sectors also have unusually generous municipal-to-Treasury yield ratios, so they should be better insulated from the negative effects of any rise in Treasury yields than would portfolios of AAA/AA credits.
InternationalInternational investment-grade markets outperformed the U.S. market by approximately 200 bps in 2012. Many of the global markets offer higher yields than the U.S., and in a year in which interest income is expected to be the primary component of return, yield differentials become more significant. Over the past two years, the extreme volatility in several eurozone markets and inflation fears in several Asian countries have kept many investors from venturing into global bond funds. In 2012, the European Union made considerable progress toward diffusing the most severe crises, and those markets appear to be functioning much better than 12 months ago. While inflation has accelerated in several countries in Asia and South America, for most of the developed world, slow growth, not rising inflation, is the dominant economic problem. In this environment, we would expect a well-diversified international bond portfolio to continue to provide somewhat better returns than a comparable domestic portfolio.
Fixed-income conclusionWe believe the current market environment is likely to prevail in 2013, and, as such, investors should continue to seek income rather than safety. Safety is simply too expensive. Income is found in some segments of the corporate, international, and municipal markets. Long-duration strategies that have outperformed in the past four years might not be as successful in 2013. In almost every market, the potential for additional price appreciation appears limited. It does not follow, however, that the potential for price declines is significant. In a slow-growth, low-inflation world economy, sharply higher bond yields are probably not sustainable.
The views expressed are as of 12-18-12 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.